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83–485 PDF 2003

S. Hrg. 107–871

OVERSIGHT OF INVESTMENT BANKS’ RESPONSE

TO THE LESSONS OF ENRON—VOL. I

HEARING

BEFORE THE

PERMANENT SUBCOMMITTEE OF INVESTIGATIONS

OF THE

COMMITTEE ON

GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

DECEMBER 11, 2002

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

JOSEPH I. LIEBERMAN, Connecticut, Chairman

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

FRED THOMPSON, Tennessee

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel

RICHARD A. HERTLING, Minority Staff Director

DARLA D. CASSELL, Chief Clerk

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

CARL LEVIN, Michigan, Chairman

DANIEL K. AKAKA, Hawaii,

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

SUSAN M. COLLINS, Maine

TED STEVENS, Alaska

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

ELISE J. BEAN, Acting Staff Director and Chief Counsel

ROBERT L. ROACH, Counsel and Chief Investigator

KIM CORTHELL, Minority Staff Director

MARY D. ROBERTSON, Chief Clerk

(III)

C O N T E N T S

Opening statements: Page

Senator Levin .................................................................................................... 1

Senator Collins ................................................................................................. 7

Senator Bennett ................................................................................................ 10

WITNESSES

WEDNESDAY, DECEMBER 11, 2002

Charles O. Prince III, Chairman and Chief Executive Officer, Citigroup Global Corporate and Investment Bank, New York, New York .............................. 12

David C. Bushnell, Managing Director, Global Risk Management, Citigroup/

Salomon Smith Barney, New York, New York .................................................. 15

Richard Caplan, Managing Director and Co-Head, Credit Derivatives Group,

Salomon Smith Barney North American Credit/Citigroup, New York, New

York ....................................................................................................................... 16

William T. Fox III, Managing Director, Global Power and Energy Group,

Citibank/Citigroup, New York, New York .......................................................... 16

Michael E. Patterson, Vice Chairman, J.P. Morgan Chase and Company,

New York, New York ........................................................................................... 44

Robert W. Traband, Vice President, J.P. Morgan Chase and Company, Houston, Texas, accompanied by Eric N. Peiffer, Vice President, J.P. Morgan

Chase and Company, New York, New York ...................................................... 46

Andrew T. Feldstein, Managing Director, Co-Head Structured Products and

Derivatives Marketing, J.P. Morgan Chase and Company, New York, New

York ....................................................................................................................... 49

Muriel Siebert, President and Chair, Muriel Siebert and Company, Inc., New

York, New York .................................................................................................... 66

Richard Spillenkothen, Director, Division of Banking Supervision and Regulation, The Federal Reserve, Washington, DC ...................................................... 71

Douglas W. Roeder, Senior Deputy Comptroller for Large Bank Supervision,

Office of the Comptroller of the Currency, Washington, DC ............................ 73

Annette Nazareth, Director, Division of Market Regulation, U.S. Securities

and Exchange Commission, Washington, DC .................................................... 75

ALPHABETICAL LIST OF WITNESSES

Bushnell, David C.:

Testimony .......................................................................................................... 15

Prepared statement .......................................................................................... 101

Caplan, Richard:

Testimony .......................................................................................................... 16

Prepared statement .......................................................................................... 103

Feldstein, Andrew T.:

Testimony .......................................................................................................... 49

Joint prepared statement ................................................................................. 107

Fox, William T. III:

Testimony .......................................................................................................... 16

Prepared statement .......................................................................................... 104

Nazareth, Annette:

Testimony .......................................................................................................... 75

Prepared statement .......................................................................................... 134

Patterson, Michael E.:

Testimony .......................................................................................................... 44

Prepared statement .......................................................................................... 105

Page

IV

Peiffer, Eric N.:

Testimony .......................................................................................................... 46

Joint prepared statement ................................................................................. 107

Prince, Charles O. III:

Testimony .......................................................................................................... 12

Prepared statement .......................................................................................... 91

Roeder, Douglas W.:

Testimony .......................................................................................................... 73

Prepared statement .......................................................................................... 123

Siebert, Muriel:

Testimony .......................................................................................................... 66

Prepared statement .......................................................................................... 113

Spillenkothen, Richard:

Testimony .......................................................................................................... 71

Prepared statement .......................................................................................... 117

Traband, Robert W.:

Testimony .......................................................................................................... 46

Joint prepared statement ................................................................................. 107

APPENDIX

Permanent Subcommittee on Investigations Staff Report on ‘‘Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions,’’ December 11, 2002 ............................... 150

EXHIBITS

VOLUME I

301. a. Bacchus, The appearance is a sale, chart prepared by the Permanent

Subcommittee on Investigations ............................................................... 185

b. Bacchus, The reality is a loan, chart prepared by the Permanent

Subcommittee on Investigations .............................................................. 186

302. a. Sundance, The appearance is a joint investment, chart prepared by

the Permanent Subcommittee on Investigations .................................... 187

b. Sundance, [The appearance is a joint investment,] The reality is a

sham investment by Citigroup, chart prepared by the Permanent

Subcommittee on Investigations .............................................................. 188

c. Sundance, The agreement included these provisions, chart prepared

by the Permanent Subcommittee on Investigations ............................... 189

303. a. $1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations ...................................................... 190

b. $1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations ...................................................... 191

c. Flagstaff-Hansen $1.4 Billion, Share Subscription/Assumption/Payment Set Off, chart prepared by the Permanent Subcommittee on

Investigations ............................................................................................. 192

d. $1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations ...................................................... 193

304. Enron Guarantees Citigroup’s ‘‘Equity’’ Investment In Bacchus, chart

prepared by the Permanent Subcommittee on Investigations .................... 194

Project Fishtail Transaction:

305. Fishtail deal structure, dated January 21, 2002, prepared by Deloitte

& Touche ......................................................................................................... 195

306. LJM2 Investment Summary for Fishtail, dated December 20, 2000 .......... 196

307. Investment Return Summary for Fishtail prepared by LJM2 ..................... 199

308. Benefits to Enron Summary, Deal Name: Ampato (Fishtail), dated December 20, 2000, prepared by LJM2 ............................................................. 200

309. Enron’s LJM2 Approval Sheet for Fishtail, dated December 18, 2000 ...... 201

310. Project Fishtail/125 Structure ....................................................................... 205

311. Structuring Summary, Project Grinch, dated December 18, 2000, prepared by Chase ............................................................................................... 206

Page

V

312. Project Grinch LP, summary memorandum prepared by Chase, December 16, 2000 ..................................................................................................... 208

313. Enron Corporate Development Asset Inventory, Tentative and Preliminary, EIM, updated 11/25/01 ....................................................................... 211

314. Enron Corp. email, December 2000/January 2001, re: 2000 Accomplishments, attaching document, Mike Patrick 2000 Accomplishments ............. 212

315. Chase fee letter to Enron Corp. signed by both parties, December 20,

2000, re: Fishtail (. . . an advisory fee in an amount equal to $500,000.

...) ................................................................................................................. 214

Project Bacchus Transaction:

316. Project Bacchus, deal structure chart prepared by Enron Corp ................. 216

317. Transaction Descriptions: Project Bacchus, Summary and Structure Description, prepared by Enron Corp ................................................................ 217

318. Global Loans Approval Memorandum, December 6, 2000, prepared by

Citibank, re: Project Bacchus ........................................................................ 219

319. Citibank email, April 2001, re: Enron Credit Approval ($200mm—Bacchus: SPV where we have a total return swap from Enron for $180

mm and verbal support for the balance . . .) ............................................... 223

320. Executive Summary, including Bacchus/Caymus Trust Facility, prepared

by Citibank ...................................................................................................... 224

321. Project Bacchus, 3% Test and Gain Calculation, prepared by Enron

Corp ................................................................................................................. 225

322. a. Citibank email, November 2000, re: Enron update (Enron’s motivation in the deal now appears to be writing up the asset in question

from a basis of about $100MM to as high as $250MM, thereby creating earnings.) .......................................................................................... 226

b. Citibank email, November 2000, re: Enron update (. . . but it will

be major appropriateness issue as will the first two) .............................. 228

c. Citibank email, November 2000, re: Enron/Bacchus Summary (They

[Enron] have offered to have the CFO discuss this at whatever level

of our [Citibank] organization we think necessary to obtain the right

comfort) ....................................................................................................... 229

d. Citibank email, December 2000, re: ENE/Bacchus Update (It is possible, but not certain, that there will be an earnings impact. . . .) ....... 232

e. Citibank email, December 2000, re: ENE/Bacchus (There are ‘‘technical’’ issues with NetWorks which MAY make Bacchus unworkable.

. . .) ............................................................................................................ 233

f. Citibank email, December 2000, re: Enron ([H]owever, the $200 million represents 16.3% and 22.4% of operating cash flow and net income . . .), attaching estimated Enron figures ........................................ 234

g. Citibank email, December 2000, re: Enron (Based on 1999 numbers

would appear that Enron significantly dresses up its balance sheet

for year end; . . .) ...................................................................................... 237

h. Citibank email, December 2000, re: Enron/Bacchus (The equity component has been approved on the basis of verbal support verified

by Enron CFO, Andy Fastow.) .................................................................. 239

i. Citibank email, December 2000, re: Enron/Bacchus (Sounds like we

made a lot of exceptions to our standard policies. . . .) .......................... 242

j. Citibank email, May 2001, re: Bacchus Unwind (. . . sufficient for

the Trust to prepay the notes in full plus break costs.) ........................... 243

323. Capital Markets Approval Committee, New Project/Complex Transaction

Description Guidelines, Enron Corp., Project Bacchus FAS 125 Transaction, 12/11/00 draft, prepared by Citibank ................................................ 244

324. Arthur Andersen LLC Memorandum, December 2000, re: Fishtail LLC

Formation/Securitization. .............................................................................. 246

325. Arthur Andersen email, November 1999, re: Total Return Swaps ............. 250

Project Sundance Transaction:

326. Description of the Sundance Transaction, 10/29/01, prepared by

Citibank ........................................................................................................... 253

Page

VI

327. Capital Markets Approval Committee (CMAC), Minutes to Meeting, May

16, 2001, Project Sundance (Enron Corp.), prepared by Citibank .............. 255

328. a. Chart prepared by Enron Corp., Sundance Steps, Updated May 16,

2001, 5pm ................................................................................................... 257

b. Sundance Steps, Updated May 11, 2001, 5:44 pm .................................. 259

c. Sundance Steps, Updated June 1, 2001 ................................................... 260

329. Enron Corp. Presentation, Enron Industrial Markets Finance Presentation of Sundance Industrial Partners, June 1, 2001 ................................. 261

330. Enron Corp. Presentation, Enron Industrial Markets—Finance, Presentation of Sundance Industrial Partners to Salomon Smith Barney, NY,

August 2001 ..................................................................................................... 264

331. Enron Corp. Presentation, Enron Industrial Markets—Finance, Potential

paper mill acquisition presentation to Salomon Smith Barney, September

2001 .................................................................................................................. 271

332. First cut at questions re Sundance, prepared by Citibank .......................... 280

333. a. Citibank email, April 2001, re: sundance ([T]he argument for why

it is debt even if we take a partnership interest that it is more debt

like than equity.) ........................................................................................ 282

b. Citibank email, May 2001, re: Enron Slapshot Structure ...................... 283

c. Citibank email, May 2001, re: Materials for CMAC meeting, attaching

copy of Capital Markets Approval Committee, New Project/Complex

Transaction Description Guidelines, Enron Corp., Project Sundance

Transaction, prepared by Citibank. .......................................................... 285

d. Citibank email, May 2001, re: cmac memo ([P]erwein wanted to say

that this is a funky deal (accounting-wise.)) ............................................ 290

e. Citibank email, May 2001, re: sundance (. . . is a structure that

insures, insofar as possible, that it will never get drawn.) ..................... 291

f. Citibank email, May 2001, re: sundance (. . . I do not understand

why we are proposing to do this transaction.) .......................................... 292

g. Citibank email, May 2001, re: Sundance ................................................ 294

h. Citibank email, May 2001, re: Treatment for Project Sundance, includes a handwritten comment that contingent capital commitment

cannot be drawn since SBHC will dissolve partnership if draws triggers are being approached.) ...................................................................... 295

i. Citibank email, May 2001, re: Enron/Sundance (Still an equity investment of sorts (acctg and tax basis for partnership) but is structured in such a way that the 670 bps is guaranteed or we blow

the deal. Also our ‘‘invest’’ is so subordinated and controlled that

it is ‘‘unimaginable’’ how our principal is not returned.) ........................ 296

j. Citibank email, May 2001, re: Sundance/Firm Investment (. . . it

does appear that we will need to have approval at some point from

Mike Carpenter . . .) ................................................................................. 297

k. Citibank (Eleanor Wagner) email, May 2001, re: Project Sundance,

including draft memo for Michael Carpenter, expressing Risk Management’s Concerns .................................................................................... 298

l. Citibank email, May 2001, re: sundance (We do still need Barbara

Yastine and Mike Carpenter to approve before we close?) ....................... 300

m. Citibank email, May 2001, re: Sundance (Approval sits in front of

Carpenter waiting for signature.) .............................................................. 301

n. Citibank email, May 2001, re: Memo on Enron-Project Sundance

(We (Bill Fox and I) share Risk’s view and if anything, feel more

strongly that suitability issues and related risks when coupled with

the returns, make it unattractive.), attaching May 2001 Dave

Bushnell Memorandum to Mike Carpenter ............................................ 302

o. Citibank email, May 2001, re: sundance ([A]ny word? am getting

a significant amount of pressure from enron to execute.) ........................ 305

p. Citibank email, June 2001, re: Sundance Closing .................................. 306

q. Citibank email, June 2001, re: Sundance Approvals (No . . . was

given a verbal go ahead . . . Understand signed is to follow.) .............. 307

r. Citibank email, June 2001, re: Sundance (Mike then had a conversation with Dave Bushnell, who shared with us Mike’s feedback.) ............ 308

Page

VII

333. a. Citibank email, April 2001, re—Continued

s. Citibank email, October 2001, re: Sundance Revenues ........................... 309

t. Citibank email, October 2001, re: sundance redux, attaching Description of the Sundance Transaction ............................................................. 310

u. Citibank email, October 2001, re: Enron Exposure on NA Credit

Derivs (Note that these equity partnerships, are designed to act as

debt exposure . . .) .................................................................................... 313

v. Citibank email, October 2001, re: ene transactions (Sundance . . .

allows Enron to manage its paper and pulp physical assets and

trading business off-balance sheet.) .......................................................... 315

w. Citibank email, October 2001, re: sundance (According to Enron,

our $28.5MM is being held in bank deposits.) ........................................ 316

x. Citibank email, November 2001, re: Sundance Paper (ENE wants

to ‘‘discuss’’ I have not reiterated the imperative nature of request,

did NOT waive the BoD stick. . . .) ......................................................... 317

y. Citibank email, November 2001, re: Enron Sundance—the paper trading partnership (Last night we came to terms with Enron for the

purchase of our interest in the Sundance partnership.) .......................... 318

334. Citibank/SolomonSmithBarney Interoffice Memo, May 2001, re: Enron

Corp.—Project Sundance (Transactions Overview, Description of the Assets, Economics) .............................................................................................. 319

335. Accounting for Investments in Limited Partnerships and Other Joint

Ownership Entities, prepared by Enron Corp .............................................. 324

336. Arthur Andersen email, August 2000, re: 4 to 1 test ................................... 334

Project Slapshot Transaction:

337. Flagstaff Funding Flows, diagram prepared by Enron Corp ...................... 347

338. Transaction Summary, Flagstaff/Enron Transaction, prepared by

JPMorgan Chase ............................................................................................. 348

339. Slapshot Savings, diagram prepared by Enron Corp .................................. 354

340. Project Slapshot, Transaction Diagram—@ Closing, June 2001, prepared

by Enron Corp. ................................................................................................ 355

341. Structuring Summary, Flagstaff Capital Corporation, February 2001,

(partial) prepared by JPMorgan Chase ......................................................... 356

342. Enron Corp. Stadacona, JPMorgan Chase presentation ............................. 362

343. Proposal to Enron Industrial Markets, Structured Canadian Financing

Transaction (Project ‘‘Slapshot’’), January 11, 2001, JPMorgan Chase

presentation .................................................................................................... 379

344. Structured Canadian Financing Transaction, Organizational Meeting,

February 8, 2001, JPMorgan Chase presentation ........................................ 396

345. Slapshot Transaction Diagram ...................................................................... 416

346. Project Slapshot, Transaction Components, June 2001, Enron Corp. presentation ............................................................................................................ 422

347. J.P. Morgan Securities Inc./Enron Corp. correspondence, June 2001, re:

Tax Comfort Letter—Enron Structured Financing ...................................... 426

348. J.P. Morgan Securities Inc./Enron Corp. correspondence, June 2001, re:

U.S. Tax Matters—Enron Structured Financing ......................................... 428

349. 206.(f) Agreement between Flagstaff Capital Corporation and Hanson

Investments Co., June 2001 ........................................................................... 431

350. Credit Agreement between Hansen Investments Co., Flagstaff Capitol

Corporation and The Chase Manhattan Bank, June 2001 ......................... 434

351. Project Slapshot, Discussion Session, March 2001, presentation prepared

by JPMorgan Chase ........................................................................................ 514

352. Tax opinion letter from Blake, Cassels & Graydon LLP to Enron Corp.,

June 2001, re: Canadian Tax Consequences of Proposed Financing .......... 525

353. Tax opinion letter from Blake, Cassels & Graydon LLP to Chase Securities, Inc., November 2000, re: Canadian Tax Consequences of Proposed

Financing ......................................................................................................... 544

354. Tax opinion memorandum from Skadden, Arps, Slate, Meagher & Flom

LLP to Enron Wholesale Services, August 2001, re: Project Slapshot ....... 565

355. Project Slapshot Structured Financing Fee Letter (Arranger), June 2001 . 593

Page

VIII

356. Fee Agreement, between J.P. Morgan Securities Inc. and Compagnie

Papiers Stadacona, June 2001 ....................................................................... 596

357. a. JPMorgan Chase email, February 2001, re: Some Good News

(Slapshot) (Bruce and Eric run the Slapshot product.) ........................... 600

b. JPMorgan Chase email, February 2001, re: Project Slapshot (The

lawyers have slammed on the brakes until we confirm that the net

accounting for the twist we’re contemplating will work.) ........................ 601

c. JPMorgan Chase email, February 2001, re: Slapshot (As discussed,

the lawyers (especially the tax lawyers) are hesitant to state explicitly

Chase’s intention to set-off . . . as they wish to keep the documents

as ‘‘arm’s length’’ as possible . . .) ............................................................ 607

d. JPMorgan Chase email, May 2001, re: Wed conf call—discussion

points, attaching Enron Discussion Points (May 9, 2001) ..................... 608

e. JPMorgan Chase emails, February and May 2001, re: Project Rio

Grande (a.k.a. Flagstaff Capital Corporation)—HEADS UP MEMO

(Club Bank Target Hold: $60MM . . ) .................................................... 611

f. JPMorgan Chase email, June 2001, re: Flagstaff I.D. #’s (The $1.1

billion will be repaid same day.) ............................................................... 613

g. Citibank email, June 2001, re: Additional Daylight Overdraft Request

from Enron (Enron will require additional daylight overdraft protection on Friday 6/22/2001 . . .) ............................................................... 614

h. JPMorgan Chase email, October 2001, re: Flagstaff Syndication Update ([L]ets make sure we lock up Citi and Boa on confidentiality

agreements, for what they’re worth.) ........................................................ 621

i. JPMorgan Chase email, October 2001, re: Enron Flagstaff (The message from Enron to them is ‘‘you have to do this.’’) ................................. 622

j. JPMorgan Chase email, November 2001, re: Enron—Flagstaff (The

papers were signed with a $56.25MM target hold to be achieved

by 9/30.) ..................................................................................................... 623

k. Eric Peiffer/JPMorgan Chase email, October 2001, re: enron responsibilities (Eric did an outstanding job and took on serious responsibilities.) ........................................................................................................... 624

358. Bill W. Brown, Accomplishments for the First Half of 2001 ....................... 626

359. Doug McDowell resume .................................................................................. 627

360. Project Slapshot brief, Project Slapshot Scores!, prepared by Enron Corp 629

361. Sundance Transaction, Slapshot Financing, prepared by Citigroup .......... 630

362. Enron Corp. email, December 2000, re: Canadian Financing Proposal

(. . . it is a similar version of an arrangement that Morris and I have

independently been developing with our Canadian counsel . . .) ............... 632

363. Enron Corporation Closing Funds Flows for Slapshot, Closing Date:

Friday, 6/22/00, Final. ................................................................................. 633

364. Memorandum prepared by Tim Edgar, Faculty of Law, The University

of Western Ontario, to the Permanent Subcommittee on Investigations,

December 9, 2002, re: Canadian Income Tax Consequences of Flagstaff/

Enron Transaction .......................................................................................... 638

365. Enron Industrial Markets Finance Presentation of Sundance and

Slapshot, March 21, 2001, prepared by Enron Corp ................................... 646

366. Citicorp/Citibank Credit Approval, Enron Corporation, December 2000,

indicating ‘‘verbal guarantees’’ of Project Bacchus ‘‘equity’’ (see page

Bates #CITI-SPSI 0128921) ........................................................................... 655

367. Accounting Schedules for Projects Fishtail and Sundance, prepared by

Enron Corp ...................................................................................................... 680

368. Letter from Skadden, Arps, Slate, Meagher & Flom LLP (attorneys

for Enron Corp.) to the Permanent Subcommittee on Investigations,

December 10, 2002, regarding status of the loans, assets, and entities

involved in the Slapshot transaction ............................................................. 684

369. JPMorgan Chase email, July 1998, attaching copy of Prepay pitch presentation ............................................................................................................ 687

370. JPMorgan Chase email, March-July 1999, re: Prepaid Forwards and

Disguised Loans .............................................................................................. 701

Page

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VOLUME II

371. Enron Net Works Partners: Valuation Analysis of Contributed Assets,

Chase Securities Inc., November 20, 2000 ................................................... 1

372. Fishtail LLC, Enron Corp. draft document summarizing Project Fishtail

(undated) ......................................................................................................... 19

373. Amended and Restated Limited Liability Company Agreement of Fishtail

LLC, December 19, 2000 ................................................................................ 22

374. Summary of Project Fishtail, prepared by Deloitte & Touche, LLP, for

the Powers Report, dated January 21, 2002 ................................................ 74

375. Data Sheet Report, Caymus Trust (c/o Wilmington Trust) as of February

22, 2002 ........................................................................................................... 102

376. Amended and Restated Limited Partnership Agreement of Sundance Industrial Partners, L.P., June 1, 2001 ............................................................ 103

377. Citibank email, June 2001, re: Apache Opportunity (Any feedback from

Carpenter on Sundance; apparently the deal closed.) .................................. 175

378. Senior Bank Contacts, document prepared by Enron Corp ......................... 176

379. Enron status as of November 26, 2001 in terms of directors, officers,

stock outstanding, and direct subsidiaries ................................................... 177

380. Enron Corp. Memorandum, October 1, 2000, re: Accounting Enron’s

Investment in Fishtail LLC ............................................................................ 191

381. Additional documents regarding Project Bacchus:

a. Enron Corp. Memorandum, December 31, 2000, re: Project Bacchus

Transaction Memorandum ........................................................................ 196

b. Fishtail Total Costs ................................................................................... 202

c. Citibank email, October 2000, re: Enron/Project Bacchus (Dan sees

NO chance that this deal will not go ahead . . .) ................................... 203

d. Citibank email, December 2000, re: Bacchus Equity (As you know

we are looking for a balance sheet provider for the new Enron trade.) . 204

e. Citibank email, December 2000, re: Enron Bacchus (Citibank GRB

have agreed to provide a 9-month facility for the 194 M and also

to take the credit risk on the equity portion.) ........................................... 205

f. Citibank fax, December 12, 2000, attaching copy with comments of

Global Loans Approval Memorandum, December 6, 2000, re: Project

Bacchus (from section on page 3 entitled, Enron Corporate Credit

Risk: Enron Corp. will essentially support the entire facility, whether

through a guaranty or verbal support.) .................................................... 206

g. Citibank email, December 2000, re: Enron follow-up (Having this

source of liquidity during this nanosecond is important in providing

certain legal opinions . . .) ....................................................................... 211

h. Citibank email, December 2000, re: Enron/Bacchus (. . . the RAP

treatment should be that the Banking Book will view the Certificates

as if it made a loan in the face amount of the Certificates.) .................. 212

i. Enron Corp. email, January 2001, re: Fishtail in EIM Partners (In

talking to Jeff, he does not like the way I was proposing that Fishtail

went into EIM Ptrs . . .) ........................................................................... 213

j. Citibank email, February 2001, re: Bacchus (I had an Enron question

regarding the Enron gty provided for Baccus(sp?).) ................................ 214

k. Citibank email, May 2001, re: phone call with bill brown ..................... 215

l. Citibank email, November 2001, re: Enron Exposure (For Bushnell),

attaching Enron exposure table ................................................................ 216

382. Additional documents regarding Project Sundance:

a. Sundance Earnings (Still Under Negotiation), document prepared by

Enron Corp ................................................................................................. 218

b. Administrative Agent Fee Calculation, document prepared by Enron

Corp ............................................................................................................ 219

c. Amended and Restated Sundance Limited Partnership Agreement,

June 1, 2001 ............................................................................................... 220

d. Final Sundance Numbers, document prepared by Enron Corp ............. 293

Page

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382. Additional documents regarding Project Sundance—Continued

e. Citibank email, May 2001, re: Sundance (Re fleet: we shd approach

these guys by saying we are rolling the trs they have on bacchus

but also adding to it.) ................................................................................ 295

f. Citibank email, May 2001, re: Sundance (Thoughts or concerns I

had as I read the revised Sundance LP Agreement:) ............................... 296

g. Citibank email, May 2001, re: sundance (. . . I do not understand

why we are proposing to do this transaction. . . .), attaching copy

of First cut at questions re Sundance ....................................................... 298

h. Citibank email, May 2001, re: Second Sundance question set, attaching copy of Second Set of Sundance Questions ....................................... 301

i. Citibank email, May 2001, re: Sundance Partnership ............................ 304

j. Enron email, May 2001, re: Updated Step by Step Sundance structure

Chart—03/22/01 ....................................................................................... 306

k. Enron Corp. Presentation, Enron Industrial Markets Finance Presentation of Sundance Industrial Partners, June 1, 2001 ........................... 311

383. Additional documents regarding Project Slapshot:

a. Flagstaff Capital Corporation, $375,000,000, Senior Credit Facility,

JPMorgan Confidential Information Memorandum, May 2001 ............. 316

b. Enron Corp. (Morris Clark to Joseph Deffner) email, undated, re:

Repatriation of Cash from Enron Canada (It should be noted that

repaying the Preferred Shares within the same year as entering into

Project Slapshot puts pressure on both of the above factors and, as

such, puts the integrity of the transaction at risk.) ................................. 352

c. Daishowa Acquisition Structure Steps, charts prepared by Enron

Corp ............................................................................................................. 353

d. JPMorgan Chase email, February 2000, re: Slapshot—Frazer Milner

Tax Opinion, attaching copy of draft opinion on Re: Canadian Structured Finance Proposal ............................................................................. 360

e. Handwritten notes of Enron Corp. re: Project Slapshot ......................... 379

f. Blake, Cassels & Graydon LLP Memorandum to Enron Corp., January 2001, re: Prepaid Forward Structure ................................................. 387

g. Enron Corp./Blake, Cassels & Graydon LLP email, February 2001,

re: Rider, attaching draft recharacterization rider ................................. 394

h. Project Slapshot, Canadian Tax Advantaged Financing Structure for

Project Crane & ECC Operations, March 20, 2001, Enron Corp. presentation ...................................................................................................... 396

i. Enron Corp. email, March 2001, re: Requirements for Right of Offset

accounting ................................................................................................... 417

j. Enron Corp./Blake, Cassels & Graydon LLP email, March 2001, re:

Canadian Guaranty Issue with attached Enron Corp. handwritten

notes re: Slapshot ...................................................................................... 418

k. Blake, Cassels & Graydon LLP Memorandum, March 2001, re: Warrant Arrangement ...................................................................................... 420

l. JPMorgan Chase email, March 2001, re: enron ...................................... 422

m. Flagstaff Capital Corporation (Delaware), Assets and Liabilities, document produced by JPMorgan Chase ......................................................... 423

n. Enron Corp./Blake, Cassels & Graydon LLP email, April 2001, re:

Comments on drafts of April 12/01, attaching copy of April 2001

Blake, Cassels & Graydon LLP Memorandum ....................................... 424

o. Blake, Cassels & Graydon LLP Draft Memorandum, May 2001, re:

Tax Issues ................................................................................................... 428

p. Enron Corp./Blake, Cassels & Graydon LLP email, May 2001, re:

Tax Benefit Analysis, attaching draft Tax Benefit Analysis ................... 432

q. Handwritten notes of Enron Corp., May 2001, re: Slapshot .................. 435

r. Enron Corp. email, May 2001, re: Journal Entries ([H]ere are accounting entries for the slapshot transaction.), attaching copy of SlapshotInitial Purchase; Slapshot—Year 1-5 Balance Sheet; and SlapshotYear 5 End Unwind ................................................................................... 436

s. Enron Corp. Memorandum, May 2001, re: Project Slapshot—Stepby-Step Description .................................................................................... 440

Page

XI

383. Additional documents regarding Project Slapshot—Continued

t. Handwritten notes of Enron Corp., June 2001, re: Slapshot ................. 443

u. Enron Corp./Blake, Cassels & Graydon LLP email, June 2001, re:

Blakes Second Set-off Opinion re: Hansen-Flagstaff, attaching Blake,

Cassels & Graydon LLP correspondence concerning Project Slapshot . 449

v. Flagstaff Capital Corporation, Commitment Allocations as of September 24, 2001 .......................................................................................... 453

w. Blake, Cassels & Graydon LLP invoice for services rendered for

the period ended June 21, 2001, re: Project Slapshot ............................ 454

x. Enron Corp. Memorandum, October 2001, re: Campagnie Papiers

Stadacona ................................................................................................... 456

y. Vinson & Elkins invoice for services posted through June 27, 2001,

re: Project Slapshot-Enron $400,000,000 Structured Financing ............ 458

z. Project Dasher, Preliminary Tax Disposition Structures To Maintain

Project Slapshot, August 31, 2001, prepared by Enron Corp ................. 459

aa. Enron Corp. email, December 2001, re: Slapshot (. . . doug, pls call

me asap since you are the most knowledgeable.) ..................................... 463

bb. Handwritten notes of Enron Corp., December 2001, re: Slapshot/

CPS restructuring with attached copy of Enron Corp. Memorandum,

December 2001, re: Proposed Sale of Stadacona Mill—Restructuring

Steps ........................................................................................................... 464

cc. Blake, Cassels & Graydon LLP Memorandum, December 2001, re:

Slapshot Restructuring/CPS Sale ............................................................ 468

dd. Enron Corp. facsimile to Jeff McMahon, December 2001, re:

Stadacona (Project Slapshot) .................................................................... 481

ee. Blake, Cassels & Graydon LLP Memorandum, January 2002, re:

Slapshot Structure, Current Status Issues and Proposed Transactions 489

ff. JPMorgan Chase email, January 2002, re: Flagstaff Commitment and

Fee Letter (Given the sensitivity to the Enron name and this transaction in particular, I would suggest writing this up as an exception.) . 494

gg. Enron Corp. Memorandum, November 2002, re: Project Slapshot—

Quarterly Payments ................................................................................... 495

hh. Patton Boggs LLP correspondence, on behalf of JPMorgan Chase,

to the Permanent Subcommittee on Investigations, December 2002,

re: structuring fees paid to JPMC ............................................................ 497

ii. Canadian Financing Strategy, A Presentation to Enron Corp., September 2000, National Australia Group .................................................. 498

jj. Additional Points, JPMorgan Chase document regarding Project

Slapshot ...................................................................................................... 510

kk. Daishowa Acquisition Structure Steps, Enron document regarding

Project Slapshot ......................................................................................... 511

384. Documents regarding Project Crane and Project Boomerang:

a. Enron Corp. email, December 2000, re: Project Crane—Status Updated and Next Steps (I would to inform everyone that yesterday

we had a meeting with Jeff Skilling to present Project Crane . . .) ...... 514

b. Enron Corp. email, December 2000, re: Skilling presentation on EIM

Pulp and Paper Market Making Strategy ................................................ 515

c. Enron Risk Assessment and Control Deal Approval Sheet, December

2000, re: Project Crane .............................................................................. 535

d. Project Crane, Steps to Acquire SAT and DFPL and Post-Acquisition

Undertakings, draft of presentation ......................................................... 542

e. Project Boomerang, Transaction Overview, prepared by JPMorgan

Chase .......................................................................................................... 548

f. JPMorgan Chase email, November 2000, re: Project Boomerang (I

think what we would like to try to do is define fair market value

in such a way that it always turns out to be equal to the value

at which the SPE purchased the business.) .............................................. 551

385. Additional documents relating to FAS 125/140 Transactions:

a. FASB Statement No. 125, Enron Corp. presentation ............................. 553

Page

XII

385. Additional documents relating to FAS 125/140 Transactions—Continued

b. Update on FASB 140, Transfers of Financial Assets & Extinguishment of Liabilities, June 2001, Enron Corp. presentation, .................... 571

c. Andersen email, November 1999, re: Total Return Swaps ..................... 584

d. Enron Corp./Andersen email, September 2001, re: Background of

Project Hawaii 125-O ................................................................................ 587

e. Enron Corp. Memorandum, December 2001, re: Hawaii Structure

Summary .................................................................................................... 590

f. Enron Corp., Pre-Tax Earnings Analysis of SFAS 140’s 1998-2001 ...... 593

g. Enron Corp. email, May 2001, re: Offshore Double Lease Accounting

Treatment ................................................................................................... 594

386. Documents relating to transactions involving Canadian Imperial Bank

of Commerce (CIBC) and Enron Corp., November, 2002 ............................ 598

387. Additional documents regarding Enron Corp. structured finance deals

generally:

a. Global Finance: Funding Vehicles, May 2000, Enron Corp. presentation .......................................................................................................... 613

b. Funds Flow Vehicles, Enron Corp. document ......................................... 621

c. Structured Finance Vehicle, August 24, 2001, Enron Corp. presentation ........................................................................................................... 629

d. Enron Corp., Structured Transactions Group Overview, June 2001 ..... 652

e. Enron Structured Finance List As of 11/16/2001 .................................. 659

388. Documents regarding Enron Bank Reviews:

a. Enron Corp. email, July 2000, re: Bank relationship review ................. 686

b. Debt Investor Relationship Review, January 2001, Enron Corp. presentation ...................................................................................................... 689

389. Documents regarding Enron Asset Valuations:

a. Whitewing Presentation, August 14, 2001, prepared by Enron Corp .... 741

b. Enron Global Assets and Services, Equity Value Schedule, $(Millions),

As of June 2001 ......................................................................................... 753

c. Enron Global Assets & Services, Significant Exposures (InUS$MM’s), . 754

390. Additional documents regarding Enron Prepay Transactions:

a. Correspondence between Citigroup and the Permanent Subcommittee

on Investigations, July 2002-January 2003, regarding Delta Energy

Corporation ................................................................................................ 755

b. Correspondence between JPMorgan Chase and the Permanent Subcommittee on Investigations, July 2002-January 2003, regarding

Mahonia, Ltd .............................................................................................. 812

c. Summary of Proposed Transaction Approval Process (TAP) Policy Revisions, undated, from the ‘‘H’’ drive of the computer of Enron Corp.

employee Rick Carson ................................................................................ 952

d. Proposed Gas Storage Monetization Structure, undated, from the ‘‘H’’

drive of the computer of Enron Corp. employee Michael Garberding ... 953

e. Enron Corp. email, December 2000, re: New Prepay with Chase (In

the prior transactions, we have received a prepayment from Mahonia

on a forward delivery schedule of fixed volumes.) ................................... 959

f. Enron Corp./JPMorgan Chase email, September 2001, re: Rep Letter

for Mahonia, attaching draft Mahonia representation letter ................. 960

g. Enron Corp. email, June 2001, re: Sample Swap Co Letter (I am

still trying to track down the original ‘‘Delta/Mahonia’’ Letter. Everyone seems to have shredded their files, which is a little disturbing.) .... 962

h. Enron Corp. email, November 2001, re: Steps for $250mm Swap

Assumption ................................................................................................ 963

i. Enron Corp. email, September 2001, re: New Confirm .......................... 967

j. Enron Corp. email, July 2001, re: Citibank/Delta Prepay (. . . the

auditors would like to verify that the MMBtus involved in the trade

are not inconsistent with normal trades that run through the financial

book for gas.) .............................................................................................. 972

Page

XIII

390. Additional documents regarding Enron Prepay Transactions—Continued

k. Enron Corp. email, September 2001, re: Revised Pre Pay docs (This

tracks language that is in the Guaranty and does not name Chase.) .... 973

l. Enron Corp. email, October 2001, re: Comments on Prepaid Swaps .... 975

m. Enron Corp. email, September 2001, re: Mahonia Confirm ................... 990

n. Enron Corp./JPMorgan Chase email, September 2001, re: Mahonia

Limited ....................................................................................................... 998

o. Enron Corp. email, November 2000, re: Sale treatment for Prepayments with subsequent participation to an investor ................................ 1001

p. Enron Corp. email, September 2001, re: Chase Prepay ......................... 1003

q. Enron Corp. email, November 2000, re: Prepay (Andy, Michael asked

me to forward this structure to you in advance of his call.) ................... 1004

r. Enron Prepaid Oil Swap: .......................................................................... 1005

391. Supplemental questions and answers for the record of Citibank, regarding December 11, 2002, hearing, dated February 27, 2003 ........................ 1006

392. Correspondence from the Board of Governors of the Federal Reserve

System, Office of the Comptroller of the Currency, Securities and Exchange Commission, to the Permanent Subcommittee on Investigations,

regarding followup to questions posed in the Subcommittee’s December

11th hearing and recommendations included in the Subcommittee report

entitled Fishtail, Bacchus, Sundance, and Slapshot, Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions .................. 1008

(1)

OVERSIGHT OF INVESTMENT BANKS’ RESPONSE TO THE LESSONS OF ENRON—VOL.

I

WEDNESDAY, DECEMBER 11, 2002

U.S. SENATE,

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS,

OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS,

Washington, DC.

The Subcommittee met, pursuant to notice, at 9:37 a.m., in room

SD–106, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding.

Present: Senators Levin, Collins, and Bennett.

Staff Present: Linda J. Gustitus, Chief of Staff; Elise J. Bean,

Staff Director and Chief Counsel; Mary D. Robertson, Chief Clerk;

Bob Roach, Counsel; Jamie Duckman, Professional Staff Member;

Jessica Swartz, Intern; Beth Merrilat-Bianchi, Detailee/IRS; Jim

Elliott, Detailee/Department of State; Kim Corthell, Republican

Staff Director; Alec Roger, Counsel to the Minority; Claire Barnard,

Investigator to the Minority; David Mount, Detailee/Secret Service;

Jim Pittrizzi, Detailee/General Accounting Office; Meghan Foley,

Staff Assistant; Marianne Upton (Senator Durbin); Tara Andringa

(Senator Levin); Bob Klepp (Governmental Affairs/Senator Thompson); Mike Nelson (Senator Bennett); Holly Schmitt (Senator

Bunning); Felicia Knight (Senator Collins); and Brooke Brewer

(Senator Cochran).

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. Good morning, everybody. One year ago, on December 2, 2001, Enron Corporation, then the seventh-largest company in the United States, declared bankruptcy. The follow-up to

this financial disaster revealed a litany of Enron corporate abuses,

from accounting fraud to price manipulation, insider dealing, and

tax abuses. Yet it is still the case today, as it was a year ago, that

most top Enron officials have walked away from the scandal that

they created with tens of millions of dollars in their pockets while

Enron employees, creditors, and shareholders have suffered substantial losses.

As disturbing as Enron’s own misconduct is the growing evidence

that leading U.S. financial institutions not only took part in

Enron’s deceptive practices, but at times designed, advanced, and

profited from them. This is the third in a series of hearings held

by this Subcommittee focusing on the role of financial institutions

in Enron’s collapse.

2

1The staff report appears in the Appendix on page 150.

Our first hearing looked at the more than $8 billion in deceptive

transactions referred to as prepays. Citigroup and J.P. Morgan

Chase repeatedly used these deceptive prepays to issue Enron huge

loans that were disguised as energy trades, which then enabled

Enron to misstate the loan proceeds as cash flow from business operations. Investors and analysts were misled, along with the many

employees who lost their life savings and jobs.

Our second hearing looked in detail at a sham asset sale from

Enron to Merrill Lynch just before the end of the year 2000 so that

Enron could book the fake sale revenue and boost both its year-end

earnings and cash flow from operations. This transaction didn’t

qualify as a true sale under accounting rules because Enron had

eliminated risk from the deal by secretly promising Merrill Lynch

to arrange a resale of the barges within 6 months, while guaranteeing a 15 percent profit.

In both hearings, substantial evidence showed that the financial

institutions involved in the deals knew exactly what was going on.

They structured the transactions, signed the paperwork, and supplied the funds, knowing that Enron was using the deal to report

that the company was in better financial condition than it really

was. In the case of Citigroup and Chase, the banks not only assisted Enron, they developed the deceptive prepays as a financial

product and sold it to other companies as so-called balance sheetfriendly financing, earning millions of fees for themselves in the

process.

Today’s hearing will look at another set of deceptive transactions

that took place over a 6-month period, from December 2000 to June

2001, involving Enron ventures in the pulp and paper business.

These transactions were known as Fishtail, Bacchus, Sundance,

and Slapshot. The evidence shows that Citigroup and Chase actively aided Enron in these transactions despite knowing that they

employed deceptive accounting or tax strategies and were being

used by Enron to manipulate its financial statements or deceptively

reduce its tax obligations. Citigroup and Chase received substantial

fees for their actions or favorable consideration from Enron in other

business dealings.

These four transactions required months of work by the Subcommittee staff to untangle. The complexity of the deals made the

deceptions almost impossible for anyone to understand without a

detailed road map. They also show how far our financial institutions have sunk in misusing structured finance. Instead of using

structured deals to lower financing costs or spread risk, which are

legitimate uses, they used structured finance to mislead investors,

analysts, and regulators about a company’s true activities and financial condition.

I will place in the record at this time the Subcommittee staff report that describes the four transactions in detail, as well as charts

and exhibits showing what happened.1

Here are some of the highlights from that report and from our

investigation. Enron constructed the first three transactions, Fishtail, Bacchus, and Sundance, as a sham asset sale of its new pulp

and paper business venture in order to inflate its cash flow and

3

1 Exhibit No. 301(a) appears in the Appendix on page 185.

2 Exhibit No. 301(b) appears in the Appendix on page 186.

3 Exhibit No. 302(a) appears in the Appendix on page 187.

earnings by hundreds of millions of dollars and to keep the substantial debts associated with this business venture off its balance

sheet and out of the view of investors and analysts.

The first two transactions took place in December 2000. Enron

first pretended to move its pulp and paper trading business off its

balance sheet to a new joint venture that it had set up called Fishtail. About 1 week later, in the Bacchus deal, Enron purportedly

sold its Fishtail interest to another entity for $200 million. Enron

then booked the $200 million as sale revenue and declared a profit

and earnings of $112 million on its year-end financial statement,

enabling the company to meet Wall Street expectations for its year

2000 earnings.

In the Bacchus transaction, Enron allegedly sold its Fishtail ownership interest to a shell company that it had established earlier

called the Caymus Trust, and Exhibit 301(a) 1 shows how the

transaction appeared on the surface, and that exhibit is on the

screen.

The Caymus Trust came up with the $200 million purchase price

by obtaining a $194 million loan from Citigroup and an apparent

$6 million cash investment from Fleet Boston Financial that was

also guaranteed by Citigroup. However, as Exhibit 301(b) 2 demonstrates, the transaction was, in reality, a loan. The evidence

shows that in addition to openly guaranteeing repayment of the

$194 million Citigroup loan, which is permissible under accounting

rules, Enron’s Chief Financial Officer, Andrew Fastow, also made

an undisclosed, oral agreement with Citigroup to ensure that

Citigroup would not incur any loss connected with the so-called $6

million investment.

These two guarantees meant that Enron, in effect, had ensured

repayment of the entire $200 million purchase price, and those two

guarantees also meant that under accounting rules, Citigroup was,

in reality, providing Enron a loan and using the Caymus Trust as

a pass-through rather than financing a real sale to a real company.

Six months later, Enron and Citigroup set up another joint venture called Sundance to take possession of all of Enron’s pulp and

paper assets, including the asset presumably just sold to the

Caymus Trust, and to keep the debt associated with these assets

off Enron’s balance sheet. But this joint venture was also a sham.

Enron’s auditor, Andersen, had told Enron that it would approve

off-balance sheet treatment of the Sundance joint venture only if at

least 20 percent of Sundance’s capital came from an independent

investor and at least 3 percent of the total capital was placed at

risk when the venture was formed and stayed at risk during the

joint venture’s operation.

Exhibit 302(a) 3 shows that Sundance appeared to meet these accounting requirements. Enron contributed approximately $750 million in assets and cash. Citigroup appeared to have contributed

$188.5 million, or 20 percent of the joint venture’s capital.

Citigroup’s contribution included $28.5 million in stock and cash,

which supposedly met the requirement for 3 percent up-front capVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
4

1 Exhibit No. 302(b) appears in the Appendix on page 188.

2 Exhibit No. 302(c) appears in the Appendix on page 189.

3 Exhibit No. 337 appears in the Appendix on page 347.

ital at risk and $160 million in unfunded capital that supposedly

would be provided on demand.

But as Exhibit 302(b) 1 shows, the reality was that Citigroup’s alleged investment was a sham because it was never intended to be

at risk. As Exhibit 302(c) 2 shows, the terms of the partnership included the following provisions. Citigroup could dissolve the partnership at any time. Enron needed to lose its entire $750 million

before any of Citigroup’s so-called investment could be touched,

which meant Citigroup would have plenty of time to dissolve the

partnership, if necessary, before it had to produce any funds. And

Sundance had to keep the $28.5 million liquid, segregated, and earmarked for Citigroup so that Citigroup could recapture that part

of its so-called investment at will.

In summary and in reality, neither Citigroup’s $28.5 million nor its unfunded $160 million were ever intended to be at risk.

The Sundance joint venture was a sham and all of its assets

should have been included in Enron’s balance sheet. Indeed, just 2

days before the transaction closed, three senior Citigroup officials

strongly urged the investment bank not to do the Sundance deal,

with one warning the following: ‘‘The GAAP accounting is aggressive and a franchise risk to us if there is publicity.’’ Let me repeat

that. Just before this deal was approved, this was the warning. It

came from Citigroup people. ‘‘The GAAP accounting is aggressive

and a franchise risk to us if there is publicity.’’ But Citigroup did the deal, earning $1.8 million in fees and preferred dividends and presumably got some good will from Enron.

Citigroup also obtained full payment of the $200 million loan that

it had provided earlier in the Bacchus deal, since one of Enron’s

contributions to Sundance was the $200 million needed to buy the

Fishtail assets from the Caymus Trust and pay off the Citigroup

loan.

On paper, Fishtail, Bacchus, and Sundance seemed to bring new

investment into Enron’s pulp and paper business venture. In reality, these complex financial deals enabled Enron to use a $200

million Citigroup loan and a sham asset sale to boost its year-end

cash flow and earnings and then quietly return the funds via

Sundance. Without Citigroup’s participation in supplying the lion’s

share of the funds, Enron would not have been able to pull off

these deceptive transactions.

Finally, the Slapshot transaction, another highly disturbing example of a major U.S. financial institution helping Enron engage

in a deceptive transaction. It is particularly disturbing because

Chase, the financial institution involved here, itself designed the

deceptive transaction. That was even more than aiding and abetting. Chase designed the Slapshot deal and sold it to Enron for $5

million, enabling Enron to claim an estimated $60 million in Canadian tax savings and $65 million in financial statement benefits.

The Slapshot sleight of hand took place on June 22, 2001. It was

designed as a tax avoidance scheme, and as we can see from the

next exhibit,3 it was a spaghetti bowl of structured finance arrangements using loans, funding transfers, and transactions involvVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
5

ing Chase and Enron affiliates in two countries, many of which

were established specifically to facilitate the deal.

In essence, Slapshot took a valid $375 million loan issued by a

consortium of banks to an Enron affiliate and combined it with a

$1 billion sham loan issued by a Chase-controlled shell company

called Flagstaff. The sham $1 billion loan created the appearance,

but not the reality, of a loan by using a shell game involving two

different transfers of $1 billion through a maze of bank accounts

belonging to Chase and Enron affiliates.

Chase provided the alleged loan by issuing a $1 billion momentary overdraft to its shell company, Flagstaff. But Chase was unwilling to allow Flagstaff to release the funds to an Enron shell

company called Hansen until Chase was sure that the $1 billion

was fully protected and going to be returned the same day, indeed,

almost at the same moment. So Chase required Enron to deposit

a separate $1 billion in an escrow account controlled by Chase before Chase would release its $1 billion to Enron. Enron obtained its

own $1 billion momentary overdraft on an account that it held at

Citibank and transferred those funds into an escrow account at

Chase.

And then through a series of near-instantaneous transactions

among Chase and Enron entities, the $1 billion sham loan was

briefly commingled with the real $375 million loan to create the appearance of a combined $1.4 billion loan to an Enron affiliate. The

sham $1 billion was then separated back out through a series of

additional transfers and moved within hours back to the Enron account at Citibank. In the meantime, the $1 billion in Enron escrow

funds was released to Chase.

Now, the $1 billion loan that was supposedly supplied by Chase

was a sham. It was issued and paid back within minutes without

any of the credit risk that is the point of a loan, even during the

few minutes that it moved from Chase’s left pocket to its right

pocket. It had no economic rationale or business purpose other

than to circulate through multiple bank accounts to create the appearance of the larger $1.4 billion loan. Chase got more than $5

million for doing it. Enron got tax deductions and better financial

statements.

Enron’s tax counsel warned that this transaction clearly involves

a degree of risk and cautioned that, ‘‘in our opinion, it is very likely

that Revenue Canada will become aware of the Slapshot transactions and upon becoming aware of them will challenge them.’’

Chase also knew that the Slapshot transaction was dubious. It

worked with Enron to minimize the possibility that Canadian tax

authorities would discover it, and they even developed contingency

plans in the event that Canada disallowed the sham loan. When

analyzing how to structure an interest rate swap that was a part

of the transaction, for instance, Enron and Chase jointly considered

three alternatives, two of which were described as disadvantageous, in part because they would produce a potential road map,

in their words, of the transaction for Revenue Canada. So instead

of following those two roads, Enron and Chase jointly chose the

third alternative, which was explicitly described as providing no

road map.

6

In addition, Enron and Chase included in the transaction documents what was called a recharacterization rider, in which they

agreed if they were caught by Revenue Canada to reclassify retroactively loan payments made by Enron to Chase to look like loans

from Enron to Chase. How is that for a move? If Canada disallowed

the Slapshot scheme and exposed Enron to additional taxes, Enron

would try to make it look as though Enron was lending money to

one of the world’s largest banks.

Slapshot was designed and intended to be a deceptive trans- action. Chase set it up to pretend that a $375 million loan was

really a $1.4 billion loan by, just for a moment, inserting an extra

$1 billion in the transaction. The combined so-called loan then provided the cover for Enron’s Canadian affiliate to claim for tax purposes that it had an outstanding loan obligation of $1.4 billion and

claim its entire $22 million quarterly loan repayment as tax deductible interest payments on the fake $1.4 billion loan, instead of

deducting only that portion of the payments that was the true interest payment on the $375 million loan.

Enron could not have completed Slapshot without a major bank like Chase which had the resources to use $1 billion for a few brief

moments and quickly move that $1 billion through multiple bank

accounts across international lines. Chase charged Enron $5 million for its so-called tax technology. Chase has also shopped that

same tax technology to other companies.

The four transactions at issue today, together with the sham

transactions examined at earlier hearings, all have deception at

their core. All misuse structured finance, which has a legitimate

purpose when used for real economic objectives, such as lowering

financing costs or spreading risk. But here, there was no such legitimate economic objective. The goal was deception, and none of

the transactions could have been executed without the complicity

and financial resources of a major financial institution.

Now, the purpose of today’s hearing is not just to expose another

set of deceptive transactions, but also to take the next step and to

determine, 1 year after the Enron scandal broke, what is being

done to prevent future deception. Citigroup and Chase have each

announced new programs designed to prevent their employees from

participating in deals that produce deceptive accounting. We need

to learn more about those programs and whether they will prevent

the type of deals that we are going to examine today.

But we also are going to find out what our financial regulators

are doing, what concrete steps they have taken to prevent U.S. financial institutions from designing, executing, and profiting from

illegitimate structured financial transactions intended to help U.S.

companies engage in misleading accounting or tax strategies. We

want to learn what concrete steps the bank regulators and the SEC

are taking, not only to punish wrongdoing on a case-by-case basis,

which is important, but also to create a deterrence program to be

part of regular bank examinations to stop future wrongdoing.

There is a regulatory gap now. The Securities and Exchange

Commission does not generally regulate banks, and bank regulators don’t regulate accounting practices or ensure accurate financial statements. Two steps need to be taken, which together could

close this gap.

7

First, the SEC should issue a policy which states clearly that the

SEC will take enforcement action against financial institutions

which aid or abet a client’s dishonest accounting by selling deceptive structured finance or tax products or by knowingly or recklessly participating in deceptive structured transactions.

Second, the bank regulators, including the Federal Reserve that

oversees our financial holding companies, need to state that violation of that SEC policy that I just described would constitute an

unsafe and unsound banking practice, thereby enabling bank examiners to take regulatory action during bank examinations.

We also need the SEC and the bank regulators to conduct a comprehensive joint review of the structured finance products being

sold by or participated in by our financial institutions so that we

can root out the ones that corrupt financial statements.

One year after Enron’s collapse, we need our regulators to tell

our banks and our security firms that the deceptions and the era

of self-regulation are over. Enron was an eye opener about the extent and the nature of corporate misconduct going on in the United

States today and the role being played by our financial institutions.

The question now is whether we have learned the Enron lessons

and whether, in addition to punishing wrongdoers on a case-bycase basis, we have taken on the tougher task of building a new

deterrence program to prevent future Enrons.

Let me call on Senator Collins, my Ranking Member for a few

more weeks and someone who has been such a great, not only supporter of efforts to protect consumers and to protect our economy,

but whose staff has been so extraordinarily helpful in the production of this report and these documents. I want to thank her. I

want to congratulate her on her new assignment as the Chair of

our full Committee, the Governmental Affairs Committee, starting

in January. But again, it has been a real pleasure serving with her,

both as her Ranking Member here and then having her as my

Ranking Member in the last few months.

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. Thank you, Senator Levin. I want to thank you

for your kind comments and your extraordinary leadership in this

very important investigation. Our staffs have worked very closely

together during the past year in what I believe has been an unprecedented level of cooperation to unravel these very complex

transactions. It would not have happened without your leadership.

I particularly want to take the opportunity to salute Linda

Gustitus, who has been the leader of your staff since, I think, 1979,

and will be retiring at the end of this year. Linda and I worked

together on the Subcommittee many, many years ago and I know

that her leadership will be sorely missed, as well.

Senator LEVIN. Thank you. Thank you for mentioning Linda, who

indeed has been absolutely at the forefront of over two decades of

investigations by this Subcommittee and by a predecessor Subcommittee that we were also both associated with. Thank you very

much for mentioning her. It is totally appropriate and, indeed, well

founded.

Senator COLLINS. Today’s hearing represents a continuation of

the Subcommittee’s extensive investigation into the collapse of the

8

Enron Corporation. It is our third hearing looking specifically at

the role played by some of America’s leading financial institutions

in transactions that enabled Enron to paint a false picture of its

financial health and that ultimately contributed to the bankruptcy

of the company.

Our earlier hearings documented that certain financial institutions, among them Merrill Lynch, J.P. Morgan Chase, and

Citigroup, knowingly participated in and indeed facilitated transactions that Enron officials used to make the company’s financial

position appear to be more robust than it actually was. These complex transactions allowed Enron to deceive its investors, its customers, and its employees.

Today’s hearing will provide additional evidence of the complicity

of certain financial institutions in Enron’s deceptions. As Senator

Levin indicated, we will closely examine four multi-million-dollar

structured finance deals that enabled Enron to produce misleading

financial statements, and in one case claim a highly questionable

$125 million tax break. Citigroup funded two of the four transactions and J.P. Morgan Chase funded the other two.

The first three transactions, known as Fishtail, Bacchus, and

Sundance, involved Enron’s so-called sale of certain assets at inflated values to special purpose entities that had been established

by Enron, Citigroup, or Chase. In each case, the entities purchasing the assets were funded with equity commitments by

Citigroup or Chase that did not truly place funds at risk or were

supported by secret oral guarantees by Enron that invalidated the

special purpose entity’s independent status.

Each of these transactions fabricated to look like an arm’s length

transaction and sale of a financial asset was, in fact, an artifice designed to enable Enron to obtain a Citicorp or a Chase loan or to

sell an asset to itself. The evidence strongly suggests that Citigroup

and Chase were not innocent pawns in these transactions. Warning

flags were abundant. As Senator Levin noted, an internal memorandum from a senior Citicorp official strongly objected to the

transactions, warning that the ‘‘accounting is aggressive and a

franchise risk to us if there is publicity.’’ Citigroup’s involvement

in helping to disguise what were essentially phony loans as phony

asset sales enabled Enron to inflate its sales revenues and produce

misleading financial statements.

The final transaction, known as Slapshot, involved a $1.4 billion

loan and related transactions that were designed to produce Canadian tax benefits for Enron. This complex web of transactions was

designed by J.P. Morgan Chase and used Enron affiliates or special

purpose entities in the United States, Canada, and the Netherlands. In simplest terms, Slapshot involved a legitimate $375 million loan issued by a consortium of banks and a phony $1 billion

loan issued by a J.P. Morgan Chase controlled SPE. The $1 billion

loan was issued and repaid on the same day through a complex series of structured finance transactions. The $375 million loan was

to be repaid over 5 years.

Chase provided the $1 billion for the phony loan by approving a

$1 billion daylight overdraft on an Enron account at Chase. The

overdraft presented no risk, however, to Chase because the bank

required Enron to deposit a separate $1 billion in an escrow acVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
9

count for the duration of the so-called loan. Chase then circulated

the $1 billion through more than a dozen bank accounts held by

Enron and Chase affiliates and SPEs, returning the $1 billion overdraft to the original Chase account by the end of the day.

The end result of these transactions was that Enron was able to

treat its quarterly $22 million loan repayments, each of which

were, in fact, a payment of principal and interest on the $375 million loan, as purely interest payments on the $1 billion loan. By

characterizing each $22 million loan payment as an interest payment on the larger loan, Enron claimed that it was entitled to deduct the entire $22 million from its Canadian taxes, for a total tax

benefit of $125 million. In return for designing this phony loan

structure and arranging the series of funding transfers, Chase received a fee of $5.25 million from Enron, and again, outside experts

cautioned Chase about this transaction.

The transactions that we are examining today once again demonstrate the extraordinary lengths to which investment banks went

to keep Enron, an important client, happy. The checks and balances that were supposed to ensure the integrity of financial transactions apparently were compromised by conflicts of interest and

the lure of big fees.

It undermines the integrity of our capital markets when some of

the most prestigious financial institutions in our country are involved in designing, marketing, executing, and profiting from financial transactions intended to enable public companies to engage in

deceptive accounting and tax strategies.

In earlier testimony, the financial institutions have generally denied any responsibility, claiming that it is simply not their fault if

their clients choose to account for these transactions improperly.

But the troubling fact remains that Enron could not have gotten

away with what it did for so long without the active participation

of its financial institutions.

Numerous documents examined by the Subcommittee clearly

demonstrate that the financial institutions that partnered with

Enron knew of the company’s intentions. In fact, in some cases, the

financial institutions helped to design the transactions specifically

so that Enron could cook its books.

For example, Chase’s own documents highlight a particular advantage of the deal as, ‘‘[not providing] a ‘road map’ for Revenue

Canada.’’ That has been explained to our staff as a selling point so

that the deal would not be easily identified by Canadian tax authorities and audited.

Today, we will also hear from the watchdogs, representatives of

the Securities and Exchange Commission, the Federal Reserve, and

the Office of the Comptroller of the Currency. There are a number

of questions about the role of the regulators. To what extent do

these regulatory agencies examine the type of transactions engaged

in by J.P. Morgan Chase and Citigroup that enabled Enron to

misrepresent its financial condition? What is their view of the legitimacy of the transactions we are examining today? Do the regulators have sufficient authority and expertise to oversee these complicated transactions? Has the current regulatory structure kept

pace with changes in the financial markets and innovations in

structured finance? The answers to these questions are critical to

10

strengthening our free enterprise system and to restoring public

confidence in our capital markets.

It is important that we remember that the Enron debacle is more

than just a tale of one company’s greed. As a result of Enron’s

downward spiral and ultimate bankruptcy, shareholders large and

small, individual and institutional, lost an estimated $60 billion.

Moreover, the collapse of Enron caused thousands of Americans to

lose jobs, to lose their savings, and to lose confidence in corporate

America and U.S. financial institutions.

When the individual investor does not have access to critical information to make wise investment decisions, information that is

known only to corporate management and their financial partners,

the playing field is far from level. We must ensure that our financial institutions act with integrity, and I want to acknowledge that

the institutions before us today have taken several steps since our

last hearings to put new safeguards in place. But we must ensure

that investors, large and small, have access to complete and accurate information to guide their investment decisions.

I look forward to hearing the testimony of our witnesses today.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Collins. Senator Bennett.

OPENING STATEMENT OF SENATOR BENNETT

Senator BENNETT. Thank you very much, Mr. Chairman. I have

not been as involved in this issue as you and Senator Collins have,

and so I will be very brief in what opening statement I have and

I will look forward to listening to the witnesses.

I do sit on the Banking Committee, which has the legislative

responsibility of coming up with changes in regulation and was involved in both the writing and in the conference report of the Sarbanes-Oxley bill that came almost exclusively as a result of the entire Enron experience. I think this hearing will be very useful,

along with the other one which you previously held, in helping us

in the Banking Committee’s responsibility to provide oversight to

both the SEC and to the bank regulators. The Banking Committee

is the place where, if legislative changes have to be made, we are

going to have to make them. This Permanent Subcommittee on Investigations has made a significant contribution to the institutional

knowledge already available to the Banking Committee and I congratulate you for focusing on this in a way that, quite frankly, we

on the Banking Committee could not.

I do have one area of concern that I simply will raise for the

record. As the previous hearing has gone forward and conducted investigations in a way that is very clearly within the purview and

charge of the Permanent Subcommittee on Investigations, some

lawyers have attempted to take statements made in that hearing,

turn them into evidence with some kind of legal alchemy, and then

make them part of a lawsuit that, unfortunate timing, is going on

right now. Fortunately, the judge ruled them out of order and refused to allow statements made at the hearing to become part of

evidence in a trial.

I would hope that will not be attempted with anything that is

said here today. This is an investigative Subcommittee. We are

probing for information. We have not come up with a final report,

11

and even when we do, I don’t think our report constitutes evidence

that can be used in a court of law to determine a fact. I think what

it says is, here are facts. Now you lawyers for one side or another

determine your own basis for these facts rather than simply

quoting us.

I wouldn’t accuse any Member of this Committee of being given

over to hyperbole in opening statements, but I do think there have

been some members of the Senate who occasionally do that, and to

take that hyperbole and try to turn it into evidence in a court of

law, I think is a little bit like what we are finding out went on

here, that is, a transaction that was intended for one purpose gets

twisted into another purpose. There are some members of the trial

bar who seem to be anxious to try to do that. They say I was glad

the judge slapped them down and said they could not do that from

previous statements that were made in these hearings and I would

hope that no one in the audience would try to do that from anything that is said here today.

With that, Mr. Chairman, again, I congratulate you for your persistence and your diligence in digging into these matters and I will

sit back and learn as much as I can from today’s witnesses.

Senator LEVIN. Thank you so much, Senator Bennett, and thank

you for your contributions in so many ways in the banking field

and many other fields, including your contribution to that Sarbanes-Oxley bill and to this Subcommittee.

Let me now turn to our witnesses. Our first panel of witnesses

is from Citigroup. I thank you all for making it here today despite

the challenging weather. We welcome Charles Prince, the Chairman and Chief Executive Officer of Citigroup Global Corporate and

Investment Bank. We welcome also David Bushnell, Managing Director and Head of Global Risk Management at Citigroup/Salomon

Smith Barney; Richard Caplan, the Managing Director and CoHead of the Credit Derivatives Group at Salomon Smith Barney

North America; and William Fox, who is the Managing Director of

the Global Power and Energy Group at Citibank.

Pursuant to Subcommittee Rule 6, all witnesses who testify before this Subcommittee are required to be sworn in, and so I would

ask you at this time to please stand and to raise your right hand.

Do you swear that the testimony that you will give before this

Subcommittee will be the truth, the whole truth, and nothing but

the truth, so help you, God?

Mr. PRINCE. I do.

Mr. BUSHNELL. I do.

Mr. CAPLAN. I do.

Mr. FOX. I do.

Senator LEVIN. Thank you very much. We will be using our traditional timing system today. At about 1 minute before the 10-

minute period for each of your testimony is up, the light will

change from green to yellow, which will give you the opportunity

to conclude your remarks. Your written testimony will be printed

in the record in its entirety. Again, we thank you for your appearance here today and for your cooperation with this investigation.

Mr. Prince.

12

1The prepared statement of Mr. Prince appears in the Appendix on page 91.

TESTIMONY OF CHARLES O. PRINCE III,1 CHAIRMAN AND

CHIEF EXECUTIVE OFFICER, CITIGROUP GLOBAL CORPORATE AND INVESTMENT BANK, NEW YORK, NEW YORK

Mr. PRINCE. Thank you, Mr. Chairman, Senator Collins, and

Senator Bennett. Good morning. My name is Chuck Prince. Since

September of this year, I have been Chief Executive Officer of

Citigroup’s Global Corporate and Investment Bank. I appreciate

the opportunity to appear before you to discuss these important

issues and I commend you on your determination to understand

how and why a Fortune 10 company like Enron could unravel so

quickly and to such devastating effect. The collapse of that company has been a disaster for thousands of people—employees, investors, and others—and making sure that similar events do not

happen again is a critically important objective that we share.

The last year has been a challenging one on Wall Street. Industry practices that were standard operating procedure for years have

come under sharp scrutiny by Congress, regulators, and investors.

Many of these practices have been changed and others are in the

process of changing. For our part at Citigroup, we want to be at

the forefront of change, setting the standard for integrity and professionalism in our industry. This has become a guiding mission for

the senior management of our entire organization.

Part of our process has included the recognition that we have engaged in certain activities that do not reflect the way we believe

business ought to be done going forward. Let me be clear, I believe

that the Citigroup professionals involved with these transactions

acted in good faith and understood these transactions to comply

with the existing law and prevailing standards of the time. But let

me be equally clear, good faith and legal compliance are no longer

the issue as far as I am concerned. Even assuming that these

transactions were entered into in good faith and were entirely lawful, they do not reflect our standards and they would not happen

now at Citigroup.

Recognizing the problems our industry faces, we have worked

diligently to develop new practices and policies reflecting the lessons we have learned. When Sandy Weill asked me to take the

helm at the Global Corporate and Investment Bank just 3 months

ago, he gave me a mandate to accelerate the process of reform and

change that was already underway. I have detailed a number of

these reforms in my written statement, but in the interest of time,

I will turn to the issue of structured transactions that is the focus

of today’s hearing and was the focus of the hearing you held, Mr.

Chairman, on July 23 of this year. As I hope you will agree when

I discuss the reform initiative we announced just 2 weeks after

your hearing and a month before I became responsible for this

business, at Citigroup, we heard you and we took appropriate action.

First, though, let me say a few words about the specific transactions under review. While I believe our people acted in good

faith, I think it is fair to say that we never anticipated that a financial intermediary like Citigroup would be criticized for the accuracy of the accounting treatment that a Fortune 10 company gave

13

to its transactions with the express approval of a then-highly respected Big Five accounting firm. At the time we entered into these

transactions, we never imagined that Arthur Andersen wouldn’t

even exist a year later or that a failure of ethics would have destroyed Enron, a company ranked in the top 20 on the list of most

admired companies in the year 2001. But we have learned a hard

and valuable lesson, that reliance on public accountants or a company’s widely held excellent reputation has significant limits, particularly in the face of corporate malfeasance.

To say that our professionals acted in good faith and in ways

they believed to be appropriate is not to say that we consider a

‘‘business as usual’’ approach to be an acceptable prescription going

forward. On the contrary, we concluded in the days and weeks following your July 23 hearing, Mr. Chairman, that we needed to act,

even in the absence of industry action or regulatory action, and

that the best way to protect both investors and our own reputation

with regard to the kinds of transactions that appropriately concern

this Committee was to insist on transparency.

Accordingly, on August 7, Citigroup announced a new transparency policy, saying, in essence, that from that day forward,

Citigroup would execute material financing transactions for companies that were not going to be recorded as debt on their balance

sheet if, but only if, that company agreed to clearly disclose the net

effect of the transaction on its financial condition.

We announced this net effect rule for two reasons: First, to encourage companies to account for financing in a transparent manner so that investors can adequately assess the net effect of the

transaction on the financial condition of the company; and second,

because we simply did not wish to be a party to transactions that

fail to meet a high standard of transparency.

Under our net effect rule, the transactions at issue in today’s

hearing would not and could not have happened at Citigroup unless Enron had made clear detailed disclosure to investors. We simply would have refused, and today would refuse, to do those transactions without a commitment to make such disclosures.

Our policy is based on a few key principles. First, it applies to

any material structured or complex financing transaction of the

sort this Subcommittee has been concerned about. In determining

whether the policy applies to a given transaction, the economic reality, not the form of the transaction, is critical.

Second, the required disclosures under our new policy include,

among other things, management’s analysis of the net effect of the

transaction on the financial condition of their company, the nature

and amount of the obligations, and a description of any events that

may cause an obligation to arise, increase, or become accelerated.

Third, Citigroup will obtain the client’s written commitment that

disclosure of such transactions in the client’s relevant public filings

will fairly present the transaction’s financial impact. If we do not

receive this commitment, we will not do the deal.

Fourth, Citigroup will do these transactions only for clients that

agree to provide the complete set of transaction documents to their

chief financial officer, their chief legal officer, and their independent auditors. If there are any oral assurances from the client

in connection with any transaction that Citigroup believes may give

14

rise to accounting or disclosure issues, these will also have to be

written down and those documents included with such transaction

documents.

Fifth, key decisions, such as whether the policy requires additional disclosures in a particular transaction, are made by senior

management from our accounting, legal, and risk management control functions acting together. If the senior managers of our control

functions do not approve a proposed transaction, then, very simply,

that transaction will not go forward. Any concerns about accounting or similar matters must be fully resolved and must be written

down, must be documented, if a transaction is to go forward.

I am personally committed to making sure that our new procedures are fully observed. In order to do that, we are enhancing our

decisionmaking process so that every step of decisions are documented, and importantly, our internal audit group will review and

verify compliance with our procedures.

Promptly after we announced this new transparency policy, we

erected what amounted to a roadblock for each structured finance

and related transaction to see whether it was the kind of transaction that would not be reflected as debt on a balance sheet and

should, therefore, be specially disclosed to the company’s investors.

None of these transactions was permitted to go forward unless it

was submitted to a rigorous examination process by a working

group from our control functions. As we move forward, we are continually adjusting and fine tuning this process to allow for more efficient, but equally rigorous, review.

We recognize, of course, that our execution will not be perfect.

We are feeling our way, seeing what works, and discovering the

challenges of applying a unilateral policy like this to an enormous

range of complex transactions. Leaders, by definition, move in uncharted territory, and we will make some mistakes.

But I am quite encouraged by what I have seen so far, by the

seriousness and intensity with which Citigroup professionals are

grappling with this new policy, from the transactional people on

the front lines to the most senior managers of our company. It has

already made a measurable difference in the kinds of deals we are

doing or declining to do and in the nature of the disclosure that clients are making.

Mr. Chairman, the world has changed a lot in the past year and

is continuing to change. The collapse of Enron and the turmoil that

followed on Wall Street has done tremendous damage to a great

many people and businesses. We recognize that we must take real

steps to change our ways of doing business and to get real results.

We have done this and we are continuing to do more. This is not

a time for half measures or foot dragging or public relations. We

at Citigroup understand our role as a leader, our responsibility in

that regard, and we embrace the mandate for change and subscribe

to the goal of effective, far-reaching reform.

We appreciate the seriousness and the vigor with which you and

the Subcommittee approach these issues, and we look forward to

working with you and your colleagues on these and other reforms.

I thank you, sir, and I look forward to answering your questions.

Senator LEVIN. Thank you so much, Mr. Prince. Mr. Bushnell.

15

1The prepared statement of Mr. Bushnell appears in the Appendix on page 101.

TESTIMONY OF DAVID C. BUSHNELL,1 MANAGING DIRECTOR,

GLOBAL RISK MANAGEMENT, CITIGROUP/SALOMON SMITH

BARNEY, NEW YORK, NEW YORK

Mr. BUSHNELL. Thank you, Mr. Chairman and Members of the

Subcommittee, for the opportunity to speak with you today. My

name is David Bushnell. I am a Managing Director at Citicorp’s

Global and Investment Bank, and I am the head of its Risk Management Division.

The Global Risk Management Division functions as an independent control over our business units. It is the responsibility of

my division to ensure that risks, including market risk, credit risk,

and risk to the institution’s reputation, are identified, measured,

and evaluated. No extension of credit is permitted without risk

management approval in accordance with our established policies

and procedures. Positions that our traders take are subject to limits established by risk management. The firm’s Risk Management

Committee, including its Capital Markets Approval Committee, report to me. I am also charged with communicating and interpreting

the risk views of senior-most management to our business units.

I understand that the Subcommittee is interested in discussing

my role in the Sundance transaction. I look forward to answering

the Subcommittee’s questions about that transaction. But before I

do, I would like to take this opportunity to explain some of the very

significant changes that Citigroup is making in the way we handle

such transactions today.

As you know, on August 7, Citigroup announced a new policy regarding transactions that raise significant accounting or disclosure

issues. As its chief risk manager, I have been centrally involved in

developing and implementing this policy. You have just heard Mr.

Prince’s testimony that describes the key elements of the policy and

our implementation program.

The message that I want to convey to you is that this new policy

is having a real impact on the ground at Citigroup where transactions are done. Every material structured or complex financing of

the sort this Subcommittee has been concerned with is being subject to a rigorous review process. The Capital Markets Approval

Committee is thoroughly evaluating the transparency of transactions and is working with our business people to ensure that in

any transaction we do, the client discloses fairly and appropriately

the net effect of that transaction on the company’s financial condition. If the client will not commit to these kinds of disclosures, the

answer is simple: Citigroup will not execute the transaction.

In the months since August 7, we have reviewed dozens of transactions and we are learning a great deal. This process is helping

us to develop a uniform approach to assessing, routing, and where

appropriate, approving and documenting transactions consistent

with the principles of our new policy, and the policy has already

had a real impact on the transactions we are declining or we are

agreeing to do.

One of the most significant objectives of the past few months has

been to embed in our culture an understanding of the importance

of this policy. I can tell you that our people are taking it seriously,

16

1The prepared statement of Mr. Caplan appears in the Appendix on page 103.

2The prepared statement of Mr. Fox appears in the Appendix on page 104.

from the front lines of our business units to our senior-most management. We are making this policy a living, breathing part of the

way we do business.

Thank you, and I look forward to answering your questions.

Senator LEVIN. Thank you, Mr. Bushnell. Mr. Caplan.

TESTIMONY OF RICHARD CAPLAN,1 MANAGING DIRECTOR

AND CO-HEAD, CREDIT DERIVATIVES GROUP, SALOMON

SMITH BARNEY NORTH AMERICAN CREDIT/CITIGROUP, NEW

YORK, NEW YORK

Mr. CAPLAN. Thank you, Mr. Chairman and Members of the Subcommittee. My name is Rick Caplan. I am a Managing Director of

Citigroup’s Global Corporate and Investment Bank and Co-Head of

the North American Credit Derivatives Group. The Credit Derivatives Group is one of several business units at Citigroup that structures sophisticated financing for clients.

I have worked in the derivatives business at Citigroup since

1997. I appreciate the opportunity to answer questions about

Project Bacchus and Project Sundance. While I want to make clear

that I understood these transactions to be appropriate under the

prevailing laws and standards, I also want to reiterate the point

that Mr. Prince made in his opening remarks. Under Citigroup’s

new structured finance policies, we will not do these transactions

today unless the client agrees to provide clear, detailed disclosure

to investors.

Thank you, Mr. Chairman and Members of the Subcommittee. I

look forward to answering your questions.

Senator LEVIN. Thank you, Mr. Caplan. Mr. Fox.

TESTIMONY OF WILLIAM T. FOX III,2 MANAGING DIRECTOR,

GLOBAL POWER AND ENERGY GROUP, CITIBANK/CITIGROUP, NEW YORK, NEW YORK

Mr. FOX. Thank you, Mr. Chairman and Members of the Subcommittee. My name is William Fox. I have worked for Citibank

since 1967. I am currently a Managing Director in the Global Relationship Bank and head of its Energy and Mining Department. I

have overall responsibility for Citibank’s relationship with clients

in the energy and mining industries.

I have been invited here today to discuss two transactions that

Citigroup executed for Enron, Project Bacchus and Project

Sundance. While I am generally familiar with Project Bacchus, my

familiarity with Project Sundance is more limited. I understand the

Subcommittee has several questions about these transactions and

Citibank’s role in them. I look forward to helping the Subcommittee

in any way that I can to answer questions about these transactions.

While we believe these transactions met applicable legal standards, they are not transactions that Citigroup would undertake

today without clear and detailed disclosure from our clients about

the net effect of those transactions on a company’s financial statements.

17

1 Exhibit No. 322(c) appears in the Appendix on page 229.

2 Exhibit No. 322(h) appears in the Appendix on page 239.

Thank you, Mr. Chairman and Members of the Subcommittee. I

look forward to answering your questions.

Senator LEVIN. Thank you so much, Mr. Fox.

Let me summarize the joint venture which we are going to start

with called Fishtail and then ask my questions.

At the end of the year 2000, Enron wanted to show a sale of the

interest that it held in a joint venture called Fishtail. They wanted

to show that sale in order to generate cash flow and earnings for

its year-end financial statement, and Enron contrived a sale of its

interest to an entity called the Caymus Trust for $200 million. The

funding for Caymus was a $194 million loan from Citibank, which

Enron in turn gave Citibank a guarantee on. The other $6 million

was listed as being an equity investment by Fleet Boston which

Citibank had guaranteed.

Now, that $6 million had to be true equity for this to be a real

sale by Enron, and Citibank understood this. If the $6 million was

a loan instead of true equity at risk, then this could not be shown

as a sale on Enron’s books and the whole purpose of the transaction would have been defeated.

But Citibank, on the other hand, wanted to reduce or eliminate

its risk on this so-called equity investment, and so Citibank went

to get an assurance from Enron’s CFO, Andy Fastow, to, in the

words of a memo, Exhibit 322 in these exhibits that are in front

of you, this is Exhibit 322(c),1 Citi was looking to obtain the right

comfort from Andy Fastow.

Mr. Fox, let me ask you these questions. You are the one who

met with Mr. Fastow to obtain this comfort for your bank. At our

staff interview, you indicated that Mr. Fastow said that Enron

would take whatever steps were necessary to make certain that

Citibank’s equity interest in Bacchus would be bought out. This

was an important transaction for Enron, according to that same

Exhibit 322(c). On the second page, this transaction was said to be

‘‘mission critical’’ by them and ‘‘a must’’ for Enron, and the words

that I have quoted were on page one of that Exhibit 322(c) when

it was said that Enron has offered to have the CFO discuss this

‘‘at whatever level of our organization we think necessary to obtain

the right comfort.’’ That is comfort now for Citibank.

First of all, looking at that Exhibit 322—I am going to change

the 322 now to Exhibit 322(h),2 if you would take a look at that.

Exhibit 322(h) is a memo or e-mail from Lydia Junek to you, Mr.

Fox, and it says that, ‘‘the equity component,’’ if you will look at

page two at the top, that ‘‘the equity component has been approved

on the basis of verbal support verified by Enron CFO Andy

Fastow.’’ So they were promising you verbal support.

First of all, who is Lydia Junek, the woman who sent you the email?

Mr. FOX. Lydia Junek is a Managing Director in our Houston office and she reports to me and did at that time, as well.

Senator LEVIN. So is it true, Mr. Fox, that Citi would not have

provided the equity for this transaction unless it had this verbal

support from Enron through Mr. Fastow?

18

1 Exhibit No. 318 appears in the Appendix on page 219.

2 Exhibit No. 366 appears in the Appendix on page 655.

Mr. FOX. Senator, this transaction was an interim bridge financing that we were engaged in. Our firm typically does not engage

in bridge financings unless we are involved in the take-out or providing the permanent financing. In this case, we were not. So for

this reason, I went and visited with Mr. Fastow because he had

control of the take-out of this transaction. He was working with another institution. So we wanted comfort from him that they were

going to take all steps necessary in order to ensure that the takeout financing was accomplished and our entire transaction would

be repaid within its terms.

Senator LEVIN. So he gave you this assurance that your so-called

investment would be repaid within that 6-month period?

Mr. FOX. He gave me the assurance that he would take all steps

necessary to make certain that the take-out financing was accomplished and, therefore, the entire Bacchus transaction would be repaid.

Senator LEVIN. Now, would you have reassessed your participation in the deal had you not obtained that support?

Mr. FOX. I believe we would have. That assurance was important

to us. As I said, we were not involved in the take-out of the financing of Bacchus, and typically our firm would not be involved in a

bridge financing that was dependent upon a take-out unless we

were involved in the take-out, and we were not in this case.

Senator LEVIN. Now, if you take a look at the top line of Exhibit

318,1 page three, it says the equity component that we provide—

this was supposed to be equity, not a loan, supposed to be equity—

will be based on verbal support committed by Andrew Fastow to

Bill Fox. It is a commitment now. It says that the verbal support—

and by the way, that verbal support was referred to a number of

times in the memo—but is it not a fact, Mr. Fox, that the verbal

support was an oral guarantee from Mr. Fastow and Enron that

your equity interest would be returned to Citi one way or another?

Mr. FOX. Senator, no, I do not believe so. We did not view it as

an oral guarantee. It was verbal support and assurance to us that

he and Enron would take all steps necessary to ensure the takeout financing, the permanent financing was accomplished so that

our entire transaction would, in fact, be repaid within its terms.

Senator LEVIN. You did not consider the support, the oral assurance, the commitment, to be a guarantee?

Mr. FOX. The oral assurance, we did not view that as a guarantee. We viewed ourselves as being at risk for that $6 million

component of the transaction.

Senator LEVIN. The bottom line is, you did not consider that to

be an oral guarantee?

Mr. FOX. We did not consider that to be an oral guarantee.

Senator LEVIN. Now take a look at Exhibit 366.2 This is a

Citibank credit approval document relating to Enron. It is dated

December 2000, the month of the Bacchus transaction. At the top

of page one, it lists Lydia Junek as the ‘‘responsible officer.’’ On the

second-to-the-last page, she has signed the document. Citi’s loan

19

and so-called equity interest in the Bacchus transaction is referred

to, if you will look at pages six and seven.

Now, the numbers are a little different, because at the time the

document was written, it was expected that Bacchus would require

a $242 million loan and $7.5 million in equity, so that is the numbers that are in there, but these amounts are the amounts that we

are referring to here. They were reduced to the $194 million loan

and $6 million in equity, but this is the same transaction, although

the numbers were slightly reduced.

Now, on page seven of this document, under the word ‘‘support’’

in the middle of that page, it says, ‘‘verbal guarantees’’ in capital

letters. You said there were no verbal guarantees. You didn’t consider them verbal guarantees. The lady who signed this document

for the bank under your supervision, in fact, said in this document

these were ‘‘verbal guarantees’’ in capital letters. Now, if they

weren’t guarantees, why did she say they were verbal guarantees?

Mr. FOX. Senator, I would not—as I said, I was the one who had

the conversation with Mr. Fastow. I was the one that understood

exactly what he said. He did not give me a verbal guarantee. I did

not seek a verbal guarantee.

Senator LEVIN. Did you ever see this document that said there

were verbal guarantees?

Mr. FOX. I don’t recall that I saw it. I may have. I probably did.

Senator LEVIN. And Ms. Junek works under your supervision?

Mr. FOX. Yes, she does, Senator.

Senator LEVIN. But you are trying, then, to make the distinction—you are trying to make a distinction that what you got is a

commitment, an assurance, that all steps necessary would be taken

to repay that money. How is that different from a guarantee? All

steps necessary means all steps necessary.

Mr. FOX. Senator, as I said before, what I obtained from Mr.

Fastow was his verbal assurance that they were going to take all

steps necessary to make certain the take-out financing was done on

a timely basis such that our entire transaction would be repaid.

Senator LEVIN. How is that different from a verbal guarantee?

‘‘All steps necessary’’ sounds to me like a guarantee, and Ms. Junek

was very straightforward under your supervision in saying it.

Mr. FOX. Senator, this——

Senator LEVIN. How is ‘‘all steps necessary’’ different from a

guarantee?

Mr. FOX. This was not legally enforceable. It was a businessman’s understanding with the company. They had control of the

take-out, they and the other financial institution they were involved in. We had no knowledge, not detailed knowledge of what

that take-out financing was going to be. So I was relying on his

verbal assurances that they were going to take the steps and they

had the wherewithal to take those steps to make certain that the

take-out financing was accomplished.

Senator LEVIN. You don’t specifically remember seeing those

words, ‘‘verbal guarantees,’’ in that document?

Mr. FOX. I do not, Senator.

Senator LEVIN. You knew that Enron was going to book this

transaction as a sale, is that not correct?

Mr. FOX. That is correct.

20

Senator LEVIN. And you also knew that if Citibank did not truly

have a 3 percent equity at risk, that it would be improper for

Enron to book the transaction as a sale?

Mr. FOX. We understood that we had to be at risk for the 3 percent of the transaction.

Senator LEVIN. Well, it seems clear to me, Mr. Fox, that Citibank

was aware that 3 percent had to be at risk. You just said so. You

had to be assured that it would not be guaranteed in order for this

to be booked as a sale. But to protect Citibank from loss, you went

out and got a verbal assurance, a commitment, a statement that

all steps necessary would be taken by Enron to pay you back. It

was characterized properly by your assistant as a verbal guarantee.

You are not a lawyer, are you, in terms of whether it is legally enforceable, or are you a lawyer?

Mr. FOX. I am not a lawyer.

Senator LEVIN. Did you receive an opinion that this was not legally enforceable?

Mr. FOX. We did not receive an opinion with respect to this aspect of the transaction. As I said earlier, my view was I was there.

What I got was assurances from Mr. Fastow that the take-out financing would be executed, and we would be paid out of the entire

transaction within its terms.

Senator LEVIN. It was clear that in doing this, you were trying

to protect yourself from loss, isn’t that correct?

Mr. FOX. No, we understood we were at risk, but since we were

not involved in the take-out and this was a short-term bridge financing, we wanted to make certain that that bridge financing was

going to be executed and we would be out of this transaction within

the terms.

Senator LEVIN. Isn’t that the same way of saying that you were

trying to protect yourself from loss?

Mr. FOX. We clearly understood we were at risk.

Senator LEVIN. But weren’t you trying to protect yourself from

any loss from the transaction?

Mr. FOX. We wanted to make certain that we were out of the

transaction on a timely basis, that is correct.

Senator LEVIN. And you were aware of the fact, I take it, that

if this assurance, commitment was a guarantee, that that would

queer the deal, is that correct?

Mr. FOX. If we had obtained a guarantee, we understood that

they could not achieve their accounting objective.

Senator LEVIN. And that would queer the deal? The transaction

would not have occurred, is that correct?

Mr. FOX. I don’t know what Enron would have done at the time,

but we certainly knew that for them to achieve their objective, accounting objective, we had to be at risk on the $6 million.

Senator LEVIN. Their financial statement, in showing this totally

as a sale, with a sale of equity, not showing any guarantee, not

showing any assurance to anybody, but just simply showing it as

a sale, was clearly deceptive. You are not going to reach a judgment on the Enron books, I assume, or are you?

Mr. FOX. No, Senator, I am not.

Senator LEVIN. Others will and others have. It was clearly deceptive. By not showing on its books that oral guarantee that it made,

21

in the words of Ms. Junek, it deceived the people who were reviewing its books, and you can split hairs and say that assurance, using

all efforts, taking all the necessary steps, commitments, doesn’t

constitute a guarantee, but it is, one, hair splitting, and two, inconsistent with your own document which says, in fact, it was an oral

guarantee.

My final question to you is, under your current standards that

Citibank has adopted, would this transaction occur?

Mr. FOX. Senator, no, it would not occur under our current

standards without complete and full disclosure of the net effect of

the transaction on Enron’s financial statements.

Senator LEVIN. Well, now, would it occur knowing what you

know?

Mr. FOX. We would have not done the transaction unless they

fully disclosed all aspects of the transaction and the net effect of

it on their financial statements.

Senator LEVIN. And had they done that in this case, based on

what you know, would this transaction have taken place?

Mr. FOX. Senator, I don’t know what they would have done at

the time, but——

Senator LEVIN. What would you do, knowing what you know?

Mr. FOX. We would have gone to Enron and asked them, under

our new standards, to have the complete, total disclosure of the net

effect of the transaction. We would have had to make certain that

their chief financial officer, general counsel were aware of the

transaction, all aspects of it, not only the written documents, but

also any oral understandings.

Senator LEVIN. What is the net effect of this transaction on

Enron? Was it in net effect a loan or net effect a sale?

Mr. FOX. They booked——

Senator LEVIN. No, I know what they booked, but you are going

to look at the net effect, right?

Mr. FOX. Right.

Senator LEVIN. Under your new standards.

Mr. FOX. Yes. We would look at the net effect.

Senator LEVIN. In your judgment, what was the net effect of this

transaction on Enron, a sale or a loan?

Mr. FOX. I think we would have required them to disclose the

conversation with me. We would have required them to disclose all

aspects of the transaction and the net impact on its financial statements. At that stage, I would assume they and their accountants

would review the transaction with their legal people and determine

how it would be booked. I am not in a position to determine how

they would have booked it. I can only suggest and require them to

have full and complete net effect exposure—disclosure.

Senator LEVIN. I am not sure, Mr. Prince, what your new standards really mean if all you are going to say is if Enron discloses

this on their books, it is OK with you, when it is so obvious, it

seems to me, to anybody that when you give a guarantee, as they

gave to you, that they would take all necessary steps to make sure

that was repaid and that they gave assurances to that. If you can

possibly then say, well, we would proceed the same way we did before providing they said that, I am not sure what your new standards really mean.

22

Mr. PRINCE. Well, Senator, you have highlighted two key differences between what happened then and what would happen

now. The first is that these oral assurances would be written down

and would be included in the transaction documents that are forwarded to the chief financial officer, the chief legal officer, and the

outside auditors, so everyone would have the same base of information.

And second, the net effect rule would require that the net effect

of the transaction, as I mentioned in my opening statement, on the

assets, the liabilities, the balance sheet, the income statement, the

net effect of all of the complicated moving around of assets would

have to be disclosed.

I think those are two very important differences between what

happened then and what happened now.

Senator LEVIN. And if they decided the net effect was a sale, that

is OK with you?

Mr. PRINCE. Well, Senator, it is not just a word, and it is not just

a sentence. They wouldn’t disclose the net effect was a sale.

Senator LEVIN. Pardon.

Mr. PRINCE. They would not, sir. They would not simply disclose

a conclusory sentence that this was a sale or not a sale. As part

of a sale, if it were a sale under the complicated accounting rules,

they would have to disclose the net effect of that sale on their balance sheet, on their income statement.

Senator LEVIN. And my question to you is, based on your study

of this record and your judgment, would you conclude and agree

that the net effect of this transaction was a sale?

Mr. PRINCE. Senator——

Senator LEVIN. If they concluded that, would you accept their

conclusion?

Mr. PRINCE. Senator, again, I am trying to answer your question.

It is more than the word ‘‘sale.’’ The net effect of the transaction,

what happens to the balance sheet, what happens to the income

statement is what our rule calls for, not the word ‘‘sale’’ or not sale.

Senator LEVIN. The net effect on the Enron financial statement

was $112 million in earnings from that transaction, but you cannot

tell us today, based on all of these documents, that if they concluded again that that was a sale, that you would not proceed with

that transaction, based on what you know?

Mr. PRINCE. Senator, I——

Senator LEVIN. You know all the underlying facts. You can say

it is not just the conclusion. I agree with you. You are going to look

at the underlying facts and conclude whether or not it is a fair

judgment that this is a sale. Otherwise, you said, it seems to me

that you are not going to proceed. My question to you is, based on

all these underlying facts which have been laid out in front of you,

would you proceed if Enron again in this kind of a situation said,

or Enron said in this kind of a situation that this was a sale?

Would you proceed?

Mr. PRINCE. Senator, if I understand your question correctly, if

you are asking me, would I make the judgment that this was a sale

or not a sale based on these various facts, I can’t make that decision sitting here today. I would want to consult with my control

23

1 Exhibit No. 322(a) appears in the Appendix on page 226.

2 Exhibit No. 322(c) appears in the Appendix on page 229.

3 Exhibit No. 322(d) appears in the Appendix on page 232.

people. I would want to have a much more rigorous review than

the detail we have had here this morning.

Senator LEVIN. Mr. Fox, you told the Subcommittee staff that

Citi had a business policy that it would not engage in structural

transactions that had a material impact on reported net income.

That was the business policy that you had, and that Citi would

look further at the project and assure itself that the project would

not impact reported net income. That was your policy in place at

the time.

Yet, throughout the Bacchus transaction, you were notified that

there was a possibility that Enron would use the transaction to report net income in its year 2000 financial statement. Exhibit

322(a) 1 is an e-mail to you and it states the following: ‘‘Enron’s motivation in the deal now appears to be writing up the asset in question from a basis of about $100 million to as high as $250 million,

thereby creating earnings.’’

Exhibit 322(c) 2 is a November 28 e-mail which states, ‘‘According

to Enron, it is possible that there will be funds flow and/or earnings impacts. Although not certain at this time, we should assume

that there will be funds flow from operations/earnings implications.’’ That is what you said you were going to assume.

Finally, on December 6, there is an e-mail, Exhibit 322(d), 3

which states, ‘‘It is probable that the monetization will add to

funds flow from operations as a portion of the assets will be from

merchant pool. It is possible but not certain that there will be earnings impact.’’ That was the last communication on the matter.

Now, did the Citibank policy then require further investigation

at that time, since there was the possibility of an earnings impact

which your policy would not permit?

Mr. FOX. Senator, the series of e-mails you referred to, starting

with the first one, certainly highlighted the potential of an earnings impact. We went back to the company. We went back to the

treasurer of the company, who confirmed to us that there would

not be significant material earnings impact.

I was shocked when I learned from your staff, which was the

first time I knew about it, that the impact of this transaction created $112 million of earnings. Quite frankly, Senator, in this particular case, we were lied to. We relied on Enron, who was the only

one that could determine the impact of a transaction as to what the

earnings impact would be.

Senator LEVIN. So that you specifically contacted Enron after

your decision that there could be an earnings impact to see whether there would be and they told you there would not be?

Mr. FOX. I did not specifically contact them.

Senator LEVIN. Who did?

Mr. FOX. Jim Reilly, who is a Managing Director of our firm. If

you go further into that last e-mail you made reference to, he reports that Enron has suggested, however, that because of their ongoing involvement in the business, it is unlikely there will be any

material earnings benefit.

24

1 Exhibit No. 322(g) appears in the Appendix on page 237.

Senator LEVIN. And you accepted that without further investigation?

Mr. FOX. We relied on Enron’s word. They were a highly respected company. They were a company we had a good relationship

with at the time and that is something we would have relied on,

yes, Senator.

Senator LEVIN. And their word was ‘‘unlikely’’?

Mr. FOX. Their word, it was unlikely that there will be any material—I don’t know what their word was. That was Mr. Reilly’s

word.

Senator LEVIN. But that was not enough, the fact that it was unlikely, still possible, investigation as your policy it seemed to me required you to do to assure yourself that there would not be an

earnings impact.

Mr. FOX. I believe that this would have sufficiently satisfied ourselves at the time.

Senator LEVIN. You were not aware yourself of the conclusion?

Mr. FOX. I was not aware. I did not have the conversations directly with the company, no, Senator.

Senator LEVIN. You had earlier, in Exhibit 322(g),1 in a memo,

you were aware of the fact that this highly reliable company, one

of the largest in the country, significantly dresses up its balance

sheets at year end. You were very much aware of Enron being

someone who liked to and was willing to and typically did dress up

their balance sheets, because you wrote in that memo that is at Exhibit 322(g) that, ‘‘based on 1999 numbers, it would appear that

Enron significantly dresses up its balance sheet for the year end.

Suspect we can expect the same this year.’’

So you were expecting a dressing up, disguise, costume by Enron

at the end of the year 2000. You had received strong suggestions

from other Citi relationship managers that it was possible that Citi

would claim earnings from the Bacchus transaction. You were told

only apparently—you are supposed to be in a position here of some

decisionmaking import—you were told that it was—you just took

Enron’s word that it was unlikely that there would be an earnings

impact. Of course, if there was an earnings impact, that violated

your policy. But knowing that this company put on a show at the

end of its year, you nonetheless, or your bank nonetheless simply

accepted their statement that it was likely that there would not be

an earnings impact. How can you explain that?

Mr. FOX. Let me comment and address that, Senator. My reference to dressing up the balance sheet is a slang reference that

a number of companies will take certain steps at various points in

their financial cycle to address balance sheet targets. They can

stretch out payables to generate cash. They can monetize or

securitize receivables to generate cash and pay down debt. They

can borrow under their bank facilities and pay down short-term

commercial paper. Many steps that large financial—I mean, large

Fortune 500 companies take to impact their balance sheet.

The context here was that I was looking at their September 1999

financial statements, reviewed them, and if I recall correctly, the

debt-to-capital ratio appeared higher than it would at year end and

25

that seemed to indicate to me that they would take certain steps

as it impacts their balance sheet. That was a balance sheet comment and statement. It was not related to the income.

Remember, at the time, Enron was an important relationship.

Enron was a highly respected company. We had no reason to suspect or believe that we could not trust and accept their word.

Senator LEVIN. Do you recall telling the Subcommittee staff that

this unlikely earnings impact conclusion was an insufficient resolution as far as you were concerned of Citi’s policy? Do you recall telling the staff that?

Mr. FOX. No, I don’t, Senator.

Senator LEVIN. All right. Let me ask you, Mr. Prince, under your

current policy, would this be a sufficient resolution?

Mr. PRINCE. Indeed not, Senator.

Senator LEVIN. This is my final question and then we will turn

it over to Senator Collins, for this round, at least. Mr. Prince, let

me first say that we all are hopeful that Citigroup’s apparent willingness to change its practice will lead to the kind of results that

you hope for and expressed in your opening statement, and I just

want to ask you some questions about your new policy.

Your new net effect rule is described as follows: Citigroup would

execute material financing transactions for companies that were

not going to be recorded as debt on their balance sheet if and only

if, as you stated, the company agreed to disclose the net effect of

the transaction on its financial condition.

The first problem that I have with this policy, or question, is that

it states that Citigroup will continue to provide financing in cases

where it knows the company isn’t going to record the debt on its

balance sheet. Doesn’t that mean that Citigroup still thinks it is

OK to sell loans that aren’t honestly reported as loans?

Mr. PRINCE. No, Senator, it does not mean that. There are many

things that are appropriately not recorded as debt on a balance

sheet. The key for us is that even if they are appropriately not recorded as debt on a balance sheet, the effect of the transaction

must be disclosed. It doesn’t matter anymore whether you do just

this much or just that much and you satisfy this little rule or that

little rule and suddenly it shifts from one shoebox to another

shoebox, or one pigeon hole to another pigeon hole. You are not

done at that point. Even if you satisfy a test and it goes to the next

category on the balance sheet, the effect of the transaction, separate from the accounting conclusion on the classification, has to be

disclosed. That is the difference.

Senator LEVIN. Are you going to make a judgment as to the fairness of the conclusion relative to net effect, or are you just going

to accept the conclusion of the other company, of your client?

Mr. PRINCE. Senator, I think one of the things that we have

learned is that we have to make our own judgments in that regard.

Senator LEVIN. Because Enron could argue, for instance, in those

prepays that we made reference to and you are aware of from an

earlier hearing, they did disclose the net effect of the transactions

because it included the energy trades in its year 2000 financial

statements. It recorded $4 billion worth of cash flow from operations, but no debt. Since Enron included the energy trades in its

financial statements as cash flow from operations, would that meet

26

your disclosure requirement, or would you look behind that and

make sure that it is a fair and accurate disclosure?

Mr. PRINCE. Senator, I think it is clearly the second. We would

require that the effect of the transaction be disclosed. So we would

require them to disclose it in a way where anyone could understand.

One of the problems that we all face is that these matters are

way too complex and getting to a simple decision shouldn’t lead to

opaqueness, shouldn’t lead to, well, now that we have got the answer from an accounting standpoint, the effect of the transaction

that goes one way or the other. Despite the accounting conclusion,

the effect of the transaction has to be disclosed.

Senator LEVIN. If I understand what you said a moment ago, not

just disclosed, but that you would reach an independent judgment

that the disclosure was a fair statement of the facts.

Mr. PRINCE. Yes, sir. We would have to be comfortable ourselves

with that disclosure.

Senator LEVIN. And one last point. In Sundance, three senior

Citigroup officials recognized the accounting problems with

Sundance and said, don’t do it. Citigroup did it anyway. What is

the solution there? If there is no agreement among your top officials, will there be a requirement that whoever approves that at a

higher level is going to have to put a stamp of approval on it?

Mr. PRINCE. Senator, as I said in my opening statement, one of

the key differences we have now is that every part of the process

has to be documented. We have to be able to pull out a paper to

put in this notebook which will say who finally and formally signed

off and why they signed off once an issue has been raised.

Senator LEVIN. Senator Collins.

Senator COLLINS. Thank you, Mr. Chairman.

Mr. Prince, I do recognize the steps that you have taken since

our last hearings to put additional safeguards in place and I don’t

minimize those actions. I think they do represent progress. But in

looking at the documents involved in these transactions, I find it

very difficult to understand how these transactions were approved

under your old procedures. There were warning flags galore, and

I want to read you some of the comments by Citigroup’s own employees, who it seems to me kept trying to raise red flags, kept trying to bring concerns to the attention of senior management.

In one e-mail, for example, an Alan McDonald says, ‘‘We, Bill Fox

and I, share risk’s view and if anything feel more strongly that the

suitability issues and related risks, when coupled with returns,

make it unattractive. It would also be an unfortunate precedent if

both GRB management relationship and risk’s views were ignored.’’

Another e-mail describes one of these transaction as ‘‘a funky

deal accounting-wise,’’ and characterizes another Citigroup employee’s view as being ‘‘amazed that they can get it off the balance

sheet.’’

Yet another e-mail, which Senator Levin has referred to, ‘‘based

on 1999 numbers would appear that Enron significantly dresses up

its balance sheet for year end; suspect we can expect the same this

year.’’

Yet another from a memo, the ‘‘accounting is aggressive and a

franchise risk to us if there is publicity.’’

27

1 Exhibit No. 322(i) appears in the Appendix on page 242.

Yet another e-mail, this one from Rick Caplan, ‘‘Sounds like

we’ve made a lot of exceptions to our standard policies. I’m sure

we’ve gone out of our way to let them know that we are bending

over backwards for them. Let’s remember to collect this IOU when

it really counts.’’

How did this happen? Why would these transactions all be approved when you have Citigroup employees raising so many red

flags, describing the accounting as ‘‘funky,’’ saying that they don’t

understand how this achieves Enron’s objectives of getting off-thebooks treatment for these transactions, saying that a lot of exceptions were made to standard policies? How could this have happened under your old procedures?

Mr. PRINCE. Senator, I will tell you honestly, I have done a lot

of soul searching about that. As the new CEO of this business, I

am responsible for it now and I am responsible for what happens

going ahead and I have to make sure that problems can’t arise

under my leadership of the business, and so I have thought a lot

about how this could have happened when the issues that you have

identified were raised.

I think, honestly, that our people did spot some of those issues,

did raise them. You have quoted the various documents. And I

think that in hindsight, our people were too comfortable with the

ability to rely on the outside auditors, on the law firms that structured and closed these transactions, and on the representations

from Enron themselves. I think that at that time we did not view

ourselves as being responsible for what Enron did with its own

books and I think we have learned a very painful lesson in that regard.

Senator COLLINS. But it wasn’t as if the representations by

Enron or Andersen or the legal team that Enron used didn’t raise

questions.

Mr. PRINCE. That is correct, Senator.

Senator COLLINS. And that is the part that is troubling. There

are some cases where there was outright deception in the information and data that were provided to you. But in other cases, the

information provided to Citigroup raised red flags and yet the

transactions went through.

Mr. PRINCE. And indeed, Senator, I think some of the language

reflects our mental state at that time. The one you quoted that said

we are surprised they can get it off their balance sheet, it is obvious that we are observing their decision process. We didn’t view

ourselves as a participant in that decision process. We were watching it. We were relying on what they told us. We were relying on

what Arthur Andersen said was OK or not from an accounting

standpoint. We have learned a painful lesson that we can’t be a bystander and just watch that process.

Senator COLLINS. Mr. Prince, how much was this driven by the

fact that there was the lure of big fees? I come back to this e-mail,

and it is Exhibit 322(i),1 where it says, ‘‘Sounds like we made a lot

of exceptions to our standard policies. I’m sure we’ve gone out of

our way to let them know that we’re bending over backwards for

28

1 Exhibit No. 318 appears in the Appendix on page 219.

them. Let’s remember to collect this IOU when it really counts.’’

What does that mean to you?

Mr. PRINCE. Well, Senator, as you know, I was not managing this

business and I wasn’t intimately involved in these transactions, but

in being briefed on these transactions, my understanding is that

the exceptions to our policies involved things like choice of law,

whether it is Texas law or New York law, things like that.

But the short answer is, I can’t put myself in the minds of the

people who did these transactions. I don’t believe that in a company like ours, an individual transaction would drive people to do

bad things. Based on what I know, I believe that our people, acting

under the rules as they understood them to be and with the clear

mental state that I mentioned a moment ago about relying on others, that they acted in good faith. That is my belief. If I did not

believe that, the people would not still be with the company. But

I believe they did act in good faith under the rules as they understood them at the time, and I don’t think that fees, whether on this

transaction or others, corrupted our organization.

Senator COLLINS. Mr. Fox, I want to follow up on your discussion

with Senator Levin, which still leaves many questions in my mind.

You traveled to Houston and met with Andrew Fastow, Enron’s

CFO at the time, because you wanted to discuss the verbal support

or the support for Citigroup’s investment in the Bacchus transaction, is that correct?

Mr. FOX. Yes. I traveled to Houston to meet with Mr. Fastow to

discuss the entire transaction and obtain his assurances that they

were going to take the necessary steps to make certain that the

take-out or permanent financing was put in place and that we

would be repaid.

Senator COLLINS. Yet in your testimony today in response to

questions from Senator Levin, you indicated that it was never your

understanding that Mr. Fastow provided you with any kind of

guarantee, is that correct?

Mr. FOX. That is correct. He did not provide me with any guarantee.

Senator COLLINS. And you also testified, and this is obviously the

critical point, that you considered Citigroup’s investment to be at

risk, is that correct?

Mr. FOX. That is correct.

Senator COLLINS. OK. Now, the reason I am having difficulties

understanding that is a document that is the loan approval memorandum, which is Exhibit 318,1 where over and over again, in fact,

I think four times in the document, there is reference to the verbal

support, the verbal commitment that you received from Mr.

Fastow.

For example, there is a sentence on page two of the memorandum in the first paragraph that says, ‘‘From our perspective,

the equity portion of the facility will be at risk and there is consequently a large element of trust and relationship rationale involved. However, this equity risk is largely mitigated by verbal

support received from Enron Corporation as per its CFO.’’ That is

29

1 Exhibit No. 366 appears in the Appendix on page 655.

obviously referring to the conversation that you had with the CFO,

is it not?

Mr. FOX. Yes, it is.

Senator COLLINS. Again in the memorandum, on page three,

there is a statement saying, ‘‘Enron’s CFO has given his verbal

commitment to Bill Fox that Enron Corporation will support the 3

percent equity piece of this transaction.’’ At the top of that page,

again, ‘‘The equity component we provide will be based on verbal

support as committed by Andrew Fastow to Bill Fox.’’ It says over

and over again in this document, which is the loan approval memorandum, that you had a verbal commitment. So I am trying to understand how you could view the funds as being truly at risk given

the verbal support of the investment that you received from Enron.

Mr. FOX. Senator, what we are doing here, I believe, in this document is trying to highlight to all that were involved in the transaction and approving it that a portion of the transaction was at

risk as equity based solely on verbal support. It did not have a

legal obligation from Enron. It did not have the faith and full faith

and credit from Enron. It was simply that Enron through Mr.

Fastow was going to make certain that the take-out transaction

was going to be accomplished.

Senator COLLINS. What did the verbal support mean and why

was it so important that it appears four times in the loan approval

memorandum?

Mr. FOX. We, I believe I would say, we were trying to highlight

the risk for all the approvers, that this was not a legal obligation

by any stretch of Enron to pay us back the $6 million. It was

verbal support. We were at risk, but we were dependent on them

to make certain that the take-out financing, the permanent financing, was going to be accomplished.

Senator COLLINS. I have to tell you that I read it exactly the opposite. If it was important enough for you to go and meet with Andrew Fastow to get that commitment, and if it appears four times

in the approval memorandum, and when there is actually a statement in this memorandum saying that the equity risk is largely

mitigated by the verbal support received from Enron, how can you

continue to maintain that this commitment really had no meaning?

Mr. FOX. I think that is just the point, Senator. It was mitigated,

not eliminated. We had that risk, and I think that is what we were

highlighting to everyone, so that everyone in our firm who was approving the transaction understood that this was an incremental

risk we were undertaking.

Senator COLLINS. On Exhibit 366,1 the phrase is used that it is

a verbal guarantee and the percentage is 100 percent. What does

that mean.

Mr. FOX. Senator, I am sorry. Where are you exactly in the exhibit?

Senator COLLINS. It is Exhibit 366. It is under ‘‘Support’’ typed

to the left. It says, ‘‘verbal guarantees,’’ ‘‘Enron Corporation,’’ ‘‘percentage: 100.’’

Mr. FOX. Yes, I am sorry.

Senator COLLINS. Doesn’t the word ‘‘guarantee’’ mean something?

30

Mr. FOX. Senator, I don’t know who completed that form, and it

is a form that gets completed, but that was not what I obtained

from Mr. Fastow, and I think what I obtained from Mr. Fastow

was generally well articulated in some of the other written documentation. I obtained from him his verbal assurance that they

would take all necessary steps to make certain that the take-out

financing was accomplished and our entire financing, not just the

equity piece but also the debt piece, would be repaid.

Senator COLLINS. So are you saying that the word ‘‘guarantee’’

should not have been used on this document?

Mr. FOX. That was not an accurate representation of my conversation with Mr. Fastow.

Mr. CAPLAN. Senator, could I make one clarification, just looking

at this for the first time?

Senator COLLINS. Yes.

Mr. CAPLAN. I am not certain that what Mr. Fox is inconsistent

with—what he is saying is inconsistent with what this says, because if you note that this section of this memo is about the term

loan, the $194 million term loan that we were providing as a

bridge, and I think you could very easily conclude that the verbal

guarantee is that Enron is going to work hard and get that takeout done at the termination of this loan. This doesn’t actually refer

to the equity at all. It seems just to refer to the term loan.

Senator COLLINS. Let me ask one final question.

Senator LEVIN. If you would yield to me on that point——

Senator COLLINS. Absolutely.

Senator LEVIN [continuing]. Because you are inaccurate. Take a

look at the prior page at the bottom. That is the term loan.

Mr. CAPLAN. Well, it says in the middle of the page, ‘‘Facility description, term loan,’’ and then——

Senator LEVIN. I understand. I know exactly what you are saying. I am saying that the larger loan, the $242 million, which was

then reduced, as I indicated in my opening statement, is on the

previous page, and that is page six. This is, without any doubt, referring to the equity, which was listed as $7.5 million, but, in fact,

as I indicated, was reduced to $6 million. But there is no doubt

that this is the equity portion, so-called equity portion, called a

term loan, by the way, in this document. I just want to—stated to

be verbal guarantees, not just mitigated, 100 percent—but the

point here is that you are wrong when you——

Mr. CAPLAN. I would agree.

Senator LEVIN. OK.

Mr. CAPLAN. But I think, though, if I might, I think this is the

beauty of our new policy, because whether we called this thing—

whether this thing turns out to be a sale or a loan, the effect of

whatever the intent behind the transaction would be disclosed in

the financials. We would require disclosure of that in the finances

of the company. I think that is really the difference we are trying

to articulate here today.

Senator COLLINS. One final question, because my time has expired. Mr. Fox, had you not received the oral commitment, whether

we are calling it a verbal guarantee or an oral commitment, from

Enron, would you have proceeded with this transaction?

31

Mr. FOX. Senator, today, I am not certain I can tell you one way

or the other. If we had not received it, it would have certainly been

a different risk, as the memo highlighted. The verbal support mitigated some of that risk. Without that, as I said earlier, it is unusual for us to engage in a bridge financing where we are not in

control or involved in the take-out. So I can’t say for certain today

whether we would or would not have gone forward without it, but

it clearly was important to us.

Senator LEVIN. Thank you. Senator Bennett.

Senator BENNETT. Thank you, Mr. Chairman.

Coming to this de novo, without the kind of research that both

my Chairman and Ranking Member have done, I have a slightly

different reaction. I think the first documents that refer to mitigation on the basis of verbal support pass the smell test. The second

document clearly does not, the one that says verbal guarantee, 100

percent, and I think that is a bureaucratic slip-up that the people

who had the conversation with Fastow—you, Mr. Fox—clearly understood you were at risk, and your first document makes it clear.

We are at risk.

Now, anybody on an approval basis reading that document says,

well, what do we have to deal with the risk, and your answer is,

I have had a conversation with Fastow and he says he is going to

take it out. That is not legally binding, it is not something we can

go to the bank with, but we are satisfied that they will make good

on it and that mitigates the risk. I think that document passes the

smell test.

But as it got handled by the sausage machine down to the final

drafting of the final loan document, that reference of a mitigation

got turned into something more than a mitigation and it came out

as a 100 percent guarantee and I think that is something you

ought to look at in terms of the way documents get drafted within

large bureaucracies. I am not surprised by it. I am not horrified by

it. It happens all the time.

But I think it is a clear message to you that when a deal is made

at your level, Mr. Fox, it gets documented to the point that when

it finally comes out in the final document that is done by an employee who is used to doing hundreds, if not thousands, of these in

a very routine way, that the significant deal you made still retains

its flavor when it comes out in the final wash. That is how I read

what happened here. Now, if you want to challenge that and say,

no, that is not where it is, looking at it strictly, as I say, de novo,

that is what I see what happened here.

So just to nail it down one last time, Mr. Fox, you were convinced, regardless of what the documents said, that Citibank really

was at risk here?

Mr. FOX. Yes, Senator, I was.

Senator BENNETT. And you were satisfied that it was a risk

Citibank could afford to take because Andy Fastow had told you,

‘‘We are going to be able to meet our obligation’’?

Mr. FOX. That is correct, Senator.

Senator BENNETT. OK. If that is all the farther it went, I think

that is a legitimate position for you to have. The difficulty comes

from what Enron did with this, and as Senator Collins said, you

understood what they were doing with this was really, to use the

32

catch-all term, very aggressive. ‘‘Very aggressive’’ usually means

getting close to the edge of something that is improper.

Now, Mr. Prince outlines the actions that Citibank is going to

take, and this is what I really want to focus on, rather than the

details of this particular situation. We are talking about a new role

for banks. In the old world, banks did not view as their role—I interrupt myself here. Let me lay it out as I see it and then you

agree or disagree.

In the old world, banks did not view their role as being watchdogs of investors and borrowers. Banks viewed their role as being

watchdogs for the investors in the bank. So as long as the bank

was satisfied that it would get its money back, it really didn’t care

what the borrowers did with the money.

Now we are saying the bank should have been part of the watchdog team that would blow the whistle and say, these guys are borrowing the money and they are going to do squirrelly things with

it on their balance sheet, and unless they disclose the real effect

on their balance sheet of taking on this loan, we are not going to

give them the loan. Is that a fair characterization of the switch in

the role of the bank that has occurred as a result of the Enron collapse?

Mr. BUSHNELL. Mr. Bennett, perhaps I could take that one. Yes,

I think that is a fair characterization of the new policy and the

switch from where we were and the policies and independencies

that we used to have versus the procedure going forward.

Senator BENNETT. It does represent a fairly significant change in

policy, because up until now, we, the Federal Government, have assumed that the role of gaining transparency in financial statements

is primarily, if not exclusively, the SEC, and as long as the SEC

does its job, the banks don’t have to worry about it. They can just

make the loan as long as they are sure their shareholders will be

taken care of and leave it up to the SEC to make sure the borrowers do the right thing with the money. Now we are saying, no,

in addition to the SEC, the banks must play a role in disclosure

to the shareholders of the borrower.

Mr. BUSHNELL. I think that is right, Senator. I think our feeling

is that, as Mr. Prince discussed in his opening remarks, this has

been such a painful process for us, even if our depositors weren’t

hurt or the bank got its money back in this case, which it did, it

has clearly been a damage to the financial system, to the trust in

the development and establishment of the smooth flowing of our

capital markets, and that in our own self-interest, if you will, we

need to make that trust come back and be a party to it.

Senator BENNETT. This raises a number of very interesting possibilities. If the bank does assume a role and, therefore, a responsibility for the accuracy of financial statements on the part of the

borrower, can the bank be sued if the borrower misstates the use

of the funds it obtains from the bank?

Mr. BUSHNELL. I understand that, Senator. I don’t think we are

looking to take on the legal responsibility or the accounting responsibility for this. We do think that there are regulatory agencies and

that is others’ jobs. We just think that when there are questions

like this, the best policy as a risk manager, transparency, shedding

33

the light on what the transaction is in plain English so that everybody can understand what happened, is the best policy for us.

Senator BENNETT. I think that is a very important point for you

to make because I don’t think you want to expose yourselves to

lawsuits on the basis that you did not adequately require transparency on the part of the borrower. I think you want to keep the

wall there that the lawsuits can go to the accounting firm that

didn’t adequately provide disclosure or require disclosure. The lawsuits obviously can go to the borrower themselves if they lied, as

Enron clearly did. But that the lawsuits can’t go to the deep pockets of a bank who, in their requirements for disclosure, fell short

of the kinds of requirements.

You want to make it clear, I think, that in the policies you are

adopting, you are adopting these policies to protect the safety and

soundness of the banks and the investment in the banks of the

banks’ shareholders. I think the case can be made that the kind of

disclosures Mr. Prince has described here do, in fact, reduce the

risk to shareholders of the bank, and by making these requirements on the part of the borrower, you are saying that the bank

will ultimately have fewer bad debts and fewer write-offs.

Let me ask the question that has not been answered here. Did you lose the $6 million? It was at risk. Did you lose it?

Mr. FOX. No, Senator. The permanent financing was executed

and the entire Bacchus financing was repaid.

Senator BENNETT. OK. Are there any other of the transactions

we will be discussing here this morning where the bank had money

at risk which you lost?

Mr. FOX. Not in the transactions that we are discussing here

today.

Senator BENNETT. OK. So the changes that Mr. Prince has talked

about, if they had been in place, would not have changed the losses

sustained by the bank. In other words, these changes would not

have retrospectively benefitted the shareholders of the bank.

Mr. FOX. I think they may have benefitted the shareholders because we wouldn’t have been associated with these transactions,

but——

Senator BENNETT. That is fair, yes. They would have affected the

shareholders in that they protect the reputation of the bank and

the reputation of the bank is obviously something that is of value

to the shareholders. So I will accept that, even if there was not a

specific monetary loss.

Mr. FOX. That is correct, but we did not lose money on these

transactions. They were repaid within—to us.

Senator BENNETT. That is my point, Mr. Chairman, and I will

stop there. I think the things we have heard from Mr. Prince are

salutary and we should congratulate Citibank on its willingness to

move forward.

I think it should be pursued, but I think everybody should be a

little careful about crossing the line and putting a liability on the

bank, any bank, if they fail to do these kind of things, because traditionally, regulation of disclosure and achieving of transparency is

something that should be accomplished by the SEC and by the

independent accountants who are paid handsomely to make sure

that there is transparency and that it should not be ultimately

34

1 Exhibit No. 322(i) appears in the Appendix on page 242.

spilled over into a lender so that a lender could be liable for making a loan where the disclosure requirements of the lender were

deemed to not be sufficient to protect the interests of the shareholders and the investor. That strikes me as very dangerous

ground that would open the door for a huge number of lawsuits,

to the detriment of everybody, if we are not very careful.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Bennett.

What we are looking into is, in addition to the changes which

Citibank is indicating it is making in the way its procedures operate, we are also looking at what it didn’t do relative to the procedures that it had in place on these transactions. This is not just

saying in hindsight that we have reached a conclusion. It is saying

that the investigation discloses that at the time these transactions

were inappropriate, that they aided and abetted deception, that

there were major concerns raised internally that were overridden,

set aside in order to please Enron or to make a fee.

This isn’t just a question of hindsight or under current rules

these transactions wouldn’t be approved. There were rules at the

time about not aiding and abetting deceptive transactions. That is

not a new rule for a bank. That is an old rule.

There is an old accounting requirement that was in existence at

the time that says there is no room for accounting representations

that subordinate substance to form, and you cannot aid and abet

a violation of that rule.

So that is our major concern here, it is the way in which major

institutions facilitated deceptive accounting and bent the rules or

violated the rules that existed at the time. Senator Collins has

made reference to this Exhibit 322(i),1 which says, ‘‘it sounds like

we made a lot of exceptions to our standard policy.’’ Those are policies that existed at the time. Those aren’t new policies. ‘‘I am sure

we have gone out of our way to let them know that we are bending

over backwards for them,’’ for Enron. ‘‘Let’s remember to collect

this IOU when it really counts. Happy holidays to all.’’

Let us move to Sundance. A few months after Bacchus, Enron

decided to create Sundance as a joint venture that would keep all

of Enron’s pulp and paper assets off its balance sheet. And, as I

discussed in my opening statement, the joint venture was a sham

because Citi really didn’t have any investment at stake, and here

are the facts.

Citibank’s $28.5 million that it was supposed to invest and have

at risk, in fact, was set aside, kept segregated, available for

Citibank. Seven-hundred-and-forty-seven million dollars of Enron’s

money would have had to have been lost before any of Citibank’s

money could be touched. Citibank could unilaterally dissolve this

venture at any time, ensuring that it wouldn’t lose anything on its

investment.

I want to go over this whole situation here with you, Mr. Caplan.

Most auditors require that for a joint venture to be unconsolidated,

the capital commitment must be split 50–50. Arthur Andersen was

a lot weaker, a lot less conservative, and the second partner in the

venture only had to put up 20 percent under Arthur Andersen’s

35

1 Exhibit No. 333(i) appears in the Appendix on page 296.

rules in order for the joint venture to be unconsolidated on the

books of Enron, and that is, of course, what Enron was interested

in. That was their goal.

Now, even with the weaker approach, the 20 percent approach,

Citi and Enron still went around it through all the ways that I discussed. Twenty-eight-point-five million dollars was segregated,

couldn’t be touched. Citibank could end this whole deal any time

it wanted. Enron’s $747 million had to all be spent before there

was even any Citi money spent at all, whether it was the $28.5

million or the balance, which I believe was $160 million.

Citibank also had a guaranteed return interest rate, and I would

like you to look at one Citi e-mail, Exhibit 333(i),1 which appears

to me to be an accurate summation of Citibank’s so-called investment in Sundance. It is supposed to be an investment at risk. Principal is supposed to be at risk.

Here is what the e-mail from Citibank says. ‘‘Still an equity investment of sorts, accounting and tax basis for partnership, but it

is structured in such a way that the 670 basis points are guaranteed or we blow the deal. Also, our invest,’’ I assume that means

investment, ‘‘is so subordinated and controlled,’’ and now these are

the key words, ‘‘that it is unimaginable how our principal is not returned,’’ Unimaginable how the principal could not be returned.

This is supposed to be an investment at risk. Guaranteed return

interest. Unimaginable, in your own words, how your principal

would not be returned. Now, how does one realistically say that

funds are at risk under those circumstances so that Enron could

keep Sundance off its balance sheet?

No one here is suggesting that you have got to go out and investigate the other guy’s balance sheets, but my gosh, this is something that you knew. You knew that your investment was so subordinated, so unlikely to be reached, so much in your control—it was

controlled by you. You could terminate that joint venture anytime

you wanted. It was unimaginable that your principal was not going

to be returned. Now, you tell me how that is an investment which

is at risk.

Mr. CAPLAN. Well, I would say a few things. First, I think it is

important to note that this structure was presented to us by Enron

in exactly this form, and our investment was absolutely in a preferred position. It was senior to Enron’s investment. They absolutely had to lose $700 million. But my choice of words would not

be ‘‘unimaginable.’’ There were many circumstances that we ran

through——

Senator LEVIN. Whose choice of words were they?

Mr. CAPLAN. Tim Leroux.

Senator LEVIN. And who is he?

Mr. CAPLAN. He is someone who works for me.

Senator LEVIN. OK. So your employee described this as unimaginable.

Mr. CAPLAN. But we spent a fair amount of time going through

scenarios in which we could lose our money in this transaction.

Now, I will submit to you that they are remote scenarios, but nevertheless, they are real. For example, one of the assets in this partVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00051 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
36

1 Exhibit No. 333(d) appears in the Appendix on page 290.

nership was a paper mill in Canada sitting on the St. Lawrence

River. If that paper mill blew up and caused significant environmental damage, we would have—our return would have been subordinated to the liability caused by that damage, and that was

something we were very concerned with in this transaction.

Senator LEVIN. Was there insurance on the paper mill, by the

way?

Mr. CAPLAN. I believe that there was insurance on the paper

mill.

Senator LEVIN. So the risk here was that the paper mill would

blow up. That risk was covered by insurance. Get to some real risk

here, will you?

Mr. CAPLAN. In addition, the way that this transaction was

structured was presented to us by Enron and it was a combination

of things. It was a combination of this preferred equity investment,

which had the full blessing of Arthur Andersen, and my understanding was the more important test was not just that we had an

equity investment, but that we had voting rights in the structure,

and we had 50 percent of the voting rights. We had the ability to

control the destiny of the entity, and if we were a creditor of the

entity, that would not be true.

So I will absolutely submit to you that this is a preferred investment. It operates much like many other preferred investments out

there, and it was not our accounting judgment as to how—as to

whether this worked or not. This is an area of—I would call this

joint venture accounting, is an area of accounting that there isn’t

a lot of literature on point and the way that our understanding is,

that joint ventures are accounted for, is that the Big Five accounting—or Big Four now—accounting firms that give guidance, and

this was Arthur Andersen’s guidance on how to account for this

transaction.

Senator LEVIN. If you look at Exhibit 333(d),1 which is an e-mail

to you, Perwein, who is a Citi tax attorney, is quoted as saying that

‘‘Sundance was a funky deal accounting-wise, and was amazed that

Enron can get it off the balance sheet.’’ Do you remember getting

this?

Mr. CAPLAN. I do.

Senator LEVIN. Do you have any reason to disagree with that?

Mr. CAPLAN. With—I am sorry.

Senator LEVIN. With the statement that it is amazing that they

could get this off the balance sheet.

Mr. CAPLAN. I am not an accountant. Neither is Mr. Perwein——

Senator LEVIN. You were aware of this tax attorney’s conclusion

that it was a funky deal accounting-wise and amazing that Enron

could get it off their balance sheet, is that right? You were aware

of that?

Mr. CAPLAN. Again, I think that is an accounting determination

made by Arthur Andersen on how the structure should work. They

were fully aware of all of the terms of the preferred investment. I

think interestingly in this e-mail, you will see later on in it where,

‘‘John C. called. He is most concerned about Garden State. I am

trying to set up an environmental call.’’ All this is indicative of our

37

1 Exhibit No. 333(t) appears in the Appendix on page 310.

2 Exhibit No. 327 appears in the Appendix on page 255.

concerns about risks in this transaction, albeit remote risks, but

real risk to our investment in the transaction.

Senator LEVIN. And is this not your words, that in Exhibit

333(t),1 that this transaction is structured to safeguard against the

possibility that we need to contribute our contingent equity and to

ensure that there is sufficient liquidity at all times to repay our

$28.5 million investment? That was ensured, wasn’t it?

Mr. CAPLAN. Well, if you think about what this was, it was a collection of fairly illiquid assets, a couple paper mills, a trading business. We were trying to mitigate our risk to the extent possible,

and to the extent we wanted to get out of the transaction, we didn’t

have creditor’s rights to call in event of default and accelerate our

debt, something like that. We only had the position of an equity

holder who could force effectively a dissolution of the company, at

which time the assets of the company would have needed to have

been liquidated. We were concerned that the assets were extremely

illiquid, so we put in steps to mitigate the illiquidity of the assets.

Senator LEVIN. Well, it was way more than that, though, Mr.

Caplan. You talk about liquidating assets. One of those assets was

an account with $28.5 million in cash which was there to protect

your $28 million, isn’t that correct?

Mr. CAPLAN. One of the assets when we closed the transaction

was $28 million of Enron commercial paper, which is a liquid asset.

It was absolutely designed to protect our ability to get out of the

transaction in what I would call a timely and efficient manner. But

again, all this was vetted fully with Enron’s accountants, and I

think this goes to the——

Senator LEVIN. I am talking about your accounts. I am talking

about your advice. Your advice was funky transaction. You don’t

know how they can do it. And you knew the $28 million is there

in an account. You insisted on it, for you. That is money to come

back to you, guaranteed. This isn’t something where you have to

liquidate an asset. You don’t liquidate something that is liquid. It

is there, set aside, isolated, segregated for Citibank. That is supposed to be an investment at risk? You call that mitigating risk?

That is not mitigating risk, it is eliminating risk on the $28.5 million. It is in a segregated account. Only you can touch it. You call

that mitigation? I call that elimination.

Mr. CAPLAN. With respect, Senator, originally, the money was in

Enron commercial paper, and if they had defaulted the day after

the transaction, if they had gone into bankruptcy the day after this

transaction had closed, our $28 million would not have been——

Senator LEVIN. Was there any suggestion that Enron was going

to go into bankruptcy at that time?

Mr. CAPLAN. No, none at all.

Senator LEVIN. You are talking about the possibility that they

would go into bankruptcy the next day, and you had the $28 million there segregated for you.

Mr. CAPLAN. I am not going to argue——

Senator LEVIN. Take a look at Exhibit 327,2 Project Sundance.

Investment in the Sundance partnership is an equity investment.

38

However—this is at the bottom of the page, number nine. ‘‘However, based on the way the deal is structured, it is more like debt

rather than equity.’’ Would you agree with that?

Mr. CAPLAN. Well, I think I would agree in the context that

Sundance as an entity had no debt, and we had a preferred position in effectively a liquidation scenario. So in that respect, it was

debt-like because it was senior in the capital structure to Enron’s

interest in the transaction.

Senator LEVIN. Senior doesn’t make it debt.

Mr. CAPLAN. Well, if the company were to liquidate and there

were debt in the company, the debt, being senior in the capital

structure, would be repaid first. Since there was no debt in the

company, our interest was the most senior interest in the company

and, therefore, any liquidation proceeds would go to pay off our investment prior to repaying Enron.

Senator LEVIN. Whose document is this, Exhibit 327? Is that

your document? I know it is a Citibank document.

Mr. CAPLAN. It is—when we have a transaction that is unusual

or the first of its kind, we have an approval committee called the

Capital Markets Approval Committee at which we discuss the

transaction. This transaction was discussed at the Capital Markets

Approval Committee——

Senator LEVIN. Was that an accurate statement, that based on

the way the deal was structured, it was more like debt rather than

equity? Is that accurate?

Mr. CAPLAN. It is accurate to the extent that Sundance as an entity had no debt. Yes, it is accurate. And understood by Enron and

their accountants as to that was the structure. I think the key

thing is, we had risk in the transaction and we had voting control,

and that was the test laid out by Andersen. It was not that our risk

was pari passu with Enron’s.

Senator LEVIN. No one is suggesting that. Let me go back to this

$28.5 million. Is it correct that a couple days before bankruptcy,

that you insisted that that $28 million come back to Citibank?

Mr. CAPLAN. We had, under the transaction documents, as a

partner in the partnership, a contractual right to call a board and

dissolve the structure at any point in time, and as Enron moved

towards bankruptcy, we effectively exercised that right.

Senator LEVIN. So your statement a few moments ago that what

would happen if Enron would go bankrupt the next day, as a matter of fact, it did go bankrupt the next 2 days after, many months

down the road, and you were then able to protect that $28 million

by terminating the deal, is that correct?

Mr. CAPLAN. We were able to exit the transaction prior to the

bankruptcy.

Senator LEVIN. Exit the transaction.

Mr. CAPLAN. If the bankruptcy had happened prior to our insistence on blowing this transaction up, we would have been at risk

on that $28 million for——

Senator LEVIN. After you knew that it was on the verge of bankruptcy, you could get your $28 million just like that, couldn’t you?

Mr. CAPLAN. That was the structure of the transaction.

Senator LEVIN. And that is what you call being at risk?

39

1 Exhibit No. 333(n) appears in the Appendix on page 302.

Mr. CAPLAN. I will not dispute with you that this is a—that the

risk here was very contingent and remote. Nevertheless, it is risk

and it was sufficient risk—I think the important point is that it

was sufficient risk for Andersen to reach its conclusion that this

joint venture would not consolidate on the balance sheet of Enron.

And I think the paradigm shift that we have implemented in our

business model now is this kind of transaction would not be—we

would not execute this kind of transaction today unless we felt that

there was clear, sufficient disclosure as to the net effect of it as to

what really goes on here to investors, and I think that is the takeaway from this. We have learned something from this transaction.

Senator LEVIN. Well, I hope the world has learned something

about this transaction, as well, and that is at the time, it was improper, not just now. At the time, it was improper.

Exhibit 333(n),1 this is what you wrote. This is from Mr.

Bushnell, he wrote to Michael Carpenter. This will be my last

question of this panel in this round. Mr. Bushnell, you wrote to Michael Carpenter, who was the head of Global Corporate and Investment Bank at the time for Citibank, on May 30, 2001, 2 days before this deal went through, and here is what you told Mr. Carpenter. This is on page two of Exhibit 333(n). ‘‘If you recall, this

is a complex structured transaction which I have refused to sign off

on.’’

And then you later said the following. ‘‘The risk management has

not approved this transaction for the following reasons,’’ and then

one of your reasons, which is the one, two, three, fourth bullet, is

that ‘‘the GAAP accounting is aggressive and a franchise risk to us

if there is publicity, a la Xerox.’’

This transaction was a franchise risk to Citibank if there was

publicity, that is what you said in this document. Were you telling

the truth?

Mr. BUSHNELL. Yes, Senator.

Senator LEVIN. And yet, you went ahead with this. This is what

really is so troubling to me from Mr. Prince’s testimony and otherwise and why the explanation that we have heard this morning is

so unsatisfying. Well, this is all something in hindsight and we

were following the rules at the time. Your own rules were bent.

You made exceptions to them. You identified this transaction as

one which would actually put the reputation of your bank at risk,

and you proceeded anyway with this transaction. This isn’t hindsight, folks. This is a lack of foresight on the part of Citibank as

to what you were up to.

How often do you write that a project or a transaction is a franchise risk? Is that a fairly common thing?

Mr. BUSHNELL. Senator, perhaps I can give some context to this

memo. First of all, I could have killed this deal and not let it go

forward. I don’t need to write a memo to kill a deal. If you read

the entirety of the memo, most of this is an alert to Mike Carpenter about some process concerns and some internal differences

between divisions about what to do with the transaction, and yes,

I do express there are some concerns about what the GAAP accounting standard is.

40

Senator LEVIN. If I could just interrupt your answer, that is not

my question, about concerns over GAAP standards. My question to

you was, how often do you write that a project or a transaction is

a franchise risk to us if there is publicity? Is that a fairly common

conclusion that you reach?

Mr. BUSHNELL. I am sorry, Senator. I was trying to get to that

point. I don’t write it often. I sit about ten yards away from Mike

Carpenter and he and I discussed lots of risk transactions, I would

say three to five times a day. Some, and I will admit that it is not

many, have an instance of reputational issues that could be there.

It is not frequent. I normally don’t write it down because I didn’t—

I just walked into Mike’s room or I called him on the phone.

In this particular instance, Mike was out of the country and I

was trying to give him something to look at. That is the reason

why I wrote it down. It is not frequent, but it is a risk issue that

we talk about in some transactions.

Senator LEVIN. A risk issue is a little bit different from saying

there is a franchise risk to us if there is publicity. Is that something that you said about many transactions that have proceeded?

Mr. BUSHNELL. Again, Senator, in terms of communications, not

many, but this isn’t the only one that we discussed reputational

issues.

Senator LEVIN. I am trying to go a little bit beyond reputational

issues. This isn’t quite that. This is your conclusion that this accounting is—it is not an issue, it is your conclusion that accounting

is so aggressive it is a franchise risk to us. You concluded that——

Mr. BUSHNELL. Yes, Senator.

Senator LEVIN [continuing]. If it is made public, and yet, it proceeded. Do you often proceed with loans, or forget that word, this

wasn’t a loan, really was a loan, but putting aside the loan-equity

question, let me get to my question. Is it common that you have

stated or concluded that accounting is so aggressive that it is a

franchise risk to us if there is publicity, and yet the transaction

nonetheless was concluded? Has that happened frequently?

Mr. BUSHNELL. It has not, no.

Senator LEVIN. Senator Collins.

Senator COLLINS. Mr. Bushnell, what was Mr. Carpenter’s response to your memo and your concerns about the Sundance deal?

Mr. BUSHNELL. Senator, I wish I could recall those concerns. As

I said, Mike was traveling at the time. He and I had hundreds of

conversations about various risk issues. We have looked back at

the record. It is clear, I think, that we had a conversation. I can’t

remember the specifics of those conversations, or indeed, how I

might have paraphrased that concern about franchise or

reputational risk or what the conversations might be.

Senator COLLINS. Initially, you refused to sign off on the transaction. Did you ultimately approve it?

Mr. BUSHNELL. Yes, I did, Senator.

Senator COLLINS. And what caused you to change your mind?

Mr. BUSHNELL. One of the very things that caused my mind is

I wanted to talk to Mike Carpenter. As I said, I could have—I

didn’t need to write a memo to not do this deal. The reason why

I sent the memo to Mike and the reason why I held up on approving the deal or declining the deal is I wanted to talk to him. I

41

1 Exhibit No. 333(r) appears in the Appendix on page 308.

wanted to alert him about several issues that I had about the way

this transaction came up, the way it was handled, and what some

of the concerns about it were.

Senator COLLINS. Did anyone at the bank direct you to approve

the transaction?

Mr. BUSHNELL. No, Senator.

Senator COLLINS. Did Mr. Carpenter provide some sort of approval for the transaction?

Mr. BUSHNELL. I can’t recall it, but I am sure he must have. If

he didn’t want the transaction to go forward, we wouldn’t have

done it.

Senator COLLINS. Are you aware that the Subcommittee has requested the paperwork authorizing the transaction, but that

Citigroup to date has failed to locate and provide that paperwork?

Mr. BUSHNELL. Yes, I am, Senator, and I think that is a breach

of our policies and procedures. We do have—for an equity investment like this, at this size, it required a sign-off from both the

Chief Financial Officer and Mike Carpenter. I believe we have provided the Subcommittee with the Chief Financial Officer’s sign-off,

but we don’t have Mike Carpenter’s sign-off in our files.

Senator COLLINS. Thank you, Mr. Chairman.

Senator LEVIN. You indicated that you remember today that you

approved this deal?

Mr. BUSHNELL. Yes, Senator.

Senator LEVIN. Because you told our staff when you were interviewed by them that you did not recall approving the deal. Has

something changed between that conversation and today?

Mr. BUSHNELL. Yes, Senator. I have seen subsequently e-mail results that give me a conclusion—I can’t recall verbally saying, ‘‘I

am OK with this deal,’’ but there is an e-mail trail that says that

I did talk with one of the transactors, a person in Mr. Caplan’s division, and that we had agreed to go forward with the transaction.

Senator LEVIN. According to this memo that I think you may be

referring to, which you say refreshed your memory, I believe this

is Exhibit 333(r),1 ‘‘If you recall, Mike Carpenter was out of the

country the day the transaction closed’’—this is dated June 29,

2001. The approval memo was given to Mike’s assistant and faxed

to him. Mike then had a conversation with Dave Bushnell, who

shared with us Mike’s feedback. We proceeded to close the transaction that day, given the absence of instructions from Mike or

Dave to the contrary.’’

Apparently, the transaction went through not because you approved it but because you didn’t give any instructions to the contrary, is that true, or did you approve it actually?

Mr. BUSHNELL. I can’t recall verbally saying I approved it. I take

this memo to mean that I had a conversation with the transactors

and said that I had talked with Mike and that met the requirements or my criteria for going forward.

Senator LEVIN. If you talked to Mike, what did he say?

Mr. BUSHNELL. Senator, as I say, I wish I could recall that. I

really do. It would make things a lot easier for all of us. And in

our new policies, this is the type of thing that we want to have

42

1 Exhibit No. 333(n) appears in the Appendix on page 302.

written down so that we can recall how we got to conclusions or

overcame issues that are brought up about structured finance

transactions. But I can’t recall the nature of that conversation.

Senator LEVIN. This is an unusual transaction. You just testified

it is uncommon that there be a transaction where you would say

there is a reputational risk serious to your bank, could actually

risk your bank’s reputation if made public. And yet, you went

ahead and approved it. You can’t remember the conversation with

Carpenter. The approval document is missing. There are a number

of very disturbing and unusual aspects to this transaction. It would

seem to me that something which is this unusual should be remembered by you in terms of your conversation with Carpenter.

Mr. BUSHNELL. Senator, I wish I could remember it, but as I

said, I had three to five conversations a day on all significant risk

transactions. This was 18 months ago, and I just can’t recall having

the conversation or, obviously, any specifics of the conversation if

I had it.

Senator LEVIN. If you look at the first page of Exhibit 333(n),1

which is an e-mail that Alan MacDonald, Head of the Global Relationship Bank, sent to Michael Carpenter the day after you wrote

your memo, that previous memo we talked about. In it, he forwards

Mr. Carpenter another copy of the memo and writes the following.

‘‘We, Bill Fox and I, share risk’s view and, if anything, feel more

strongly that suitability issues and related risks, when coupled

with the returns, make it unattractive. It would be an unfortunate

precedent if both GRB relationship management and risk’s views

are ignored.’’

Mr. Fox, Mr. MacDonald writes that you shared the views of Mr.

Bushnell. Did you have concerns about this project?

Mr. FOX. I had some questions about the project, mostly surrounding the returns we were attempting to achieve. I was concerned that it was going to potentially disenfranchise another product area of ours called capital structuring. Initially, I had raised

some issues concerning the fact that I didn’t understand how the

accounting was able to achieve Enron’s objectives. Those were the

areas of my concern.

Senator LEVIN. Were you satisfied?

Mr. FOX. With respect to the accounting question, I received an

e-mail back from an individual that confirmed that Arthur Andersen had reviewed and utilized this type of structure elsewhere.

Senator LEVIN. And what about the reference to the franchise

risk if there is publicity?

Mr. FOX. I had not seen Mr. Bushnell’s memo until after the fact.

My communication, though I don’t recall it, must have been with

Mr. MacDonald directly.

Senator LEVIN. So here, we have got serious concerns raised by

Mr. Bushnell and Mr. Fox about the accounting associated with it.

You, at least, Mr. Bushnell, about the risk to the bank’s reputation.

You, Mr. Bushnell, as head of risk management, refused to sign off

on the project because, in part, the aggressive accounting did create

a franchise risk if it was made public, if it came to light. And yet,

the deal went through, helped Enron to make its balance sheet look

43

a lot better than it was entitled to look, and I am afraid that that

story is a sad story.

This is not just a story about should we make banks look at the

books of clients. This is a story of how a bank with serious concerns, even to its reputation, was willing to proceed with a transaction which its own people thought was incredible in terms of its

accounting techniques, and nonetheless, you went ahead and did it.

You did it for a couple of reasons, I assume. One was there was

money in it, and two, you wanted to keep a good client happy.

But I do think it is important as we look at what our regulators

are going to do about it and what your new procedures are to hopefully stop this from happening, that we recognize that these are

problems that were raised at the time. This is not retroactive applying new standards. This is looking at how a bank of high reputation that should be a pillar in our economy stooped pretty low.

We have got to learn from that lesson. The bank says it has. I am

glad to hear you have. I hope you have. For the sake of our economy, I even pray you have, because this has got to stop.

We are going to rely to some extent on self-regulation, but we

cannot rely totally or even to a great degree on self-regulation because it hasn’t worked in the past. There is too much temptation

out there, to please customers and to make money, and I guess

those are one and the same thing. And so we are going to need to

talk to our regulators, and we will a little later on today, after we

talk to Chase, as to how we, as a government, can be sure that

these kind of activities are not repeated.

I want to thank our witnesses. Again, I know this was a difficult

day for you to get here. We also want to again repeat that Citibank

as well as Chase has cooperated in our investigation. You have provided us with documents, obviously, and you have appeared. You

have come and been interviewed by us, and those are important

pluses on the ledger. We thank you and you are excused.

Mr. BUSHNELL. Thank you, Senator.

Mr. CAPLAN. Thank you, Senator.

Mr. FOX. Thank you, Senator.

Senator LEVIN. We are going to take a 5 minute recess.

[Recess.]

Senator LEVIN. We will come back to order. I would like to call

now our second panel of witnesses. I want to thank all of you, as

I did our first panel, for making it here in this weather. It was bad

enough when you got here. I think it is worse now. I don’t know

if that is good news or bad news, but it is the fact, apparently.

We want to welcome Michael Patterson, who is the Vice President of J.P. Morgan Chase and Company; Andrew Feldstein, the

Managing Director and Co-Head of Structured Products and Derivatives Marketing at J.P. Morgan Chase; Robert Traband, Vice

President of J.P. Morgan Chase in Houston; and Eric Peiffer, a

Vice President of J.P. Morgan Chase in New York.

Pursuant to Rule 6, witnesses who testify before the Subcommittee are required to be sworn and so I would ask you all to

please stand and raise your right hand.

Do you swear that the testimony that you will give before this

Subcommittee will be the truth, the whole truth, and nothing but

the truth, so help you, God?

44

1The prepared statement of Mr. Patterson appears in the Appendix on page 105.

Mr. PATTERSON. I do.

Mr. FELDSTEIN. I do.

Mr. TRABAND. I do.

Mr. PEIFFER. I do.

Senator LEVIN. As I mentioned before, a minute before the red

light comes on signaling that you should end your testimony, you

will be given a green to yellow light, which will give you the opportunity to conclude your remarks. We will print testimony in its entirety in the record, so we would ask you to limit your oral testimony to no more than 10 minutes.

Mr. Feldstein.

Mr. PATTERSON. Mr. Chairman, with your permission, may I

begin?

Senator LEVIN. Sure. Do you want to start off?

Mr. PATTERSON. Yes, sir.

Senator LEVIN. Sure. Mr. Patterson.

TESTIMONY OF MICHAEL E. PATTERSON,1 VICE CHAIRMAN,

J.P. MORGAN CHASE AND COMPANY, NEW YORK, NEW YORK

Mr. PATTERSON. Mr. Chairman and Members of the Subcommittee, my name is Michael Patterson. I am a Vice Chairman

of J.P. Morgan Chase and head of the firm’s Policy Review Office

since August of this year.

I am joined today by my colleagues Andrew Feldstein, a Managing Director and Co-Head of Structured Products and Derivatives

Marketing since March of this year; Robert Traband, a Vice President of J.P. Morgan Chase; and Eric Peiffer, also a Vice President

of the bank. After my statement, Mr. Traband will read a joint

statement for himself and Mr. Peiffer, and with the permission of

the Subcommittee, Mr. Feldstein will then give a brief opening

statement.

Senator LEVIN. That is fine.

Mr. PATTERSON. I am pleased to be here to discuss the firm’s

policies and practices regarding transactions with publicly traded

U.S. companies. As requested in your invitation letter, I will address policies and practices relating most particularly to structured

finance, accounting, and tax matters.

J.P. Morgan Chase and its predecessor firms have long had in

place policies and procedures governing transactions with clients.

These policies and procedures address, among many other subjects,

compliance with external legal and regulatory requirements, as

well as the aspects of the transaction that could raise reputation

risk for the firm. These policies and procedures are periodically reviewed and updated to take account of our experience and external

developments.

Structured finance encompasses a wide variety of transactions

and instruments designed to help clients achieve their risk management, financing liquidity, and other financial objectives within

the framework of applicable and often complex legal, regulatory,

tax, and accounting rules and principles. Securitization, special

purpose vehicles, and derivatives are among the well-recognized

45

techniques used to allocate risks, capital, and cash flows to meet

client objectives.

To make sure that our structured finance transactions comply in

all respects with that framework, the business transaction approval

process requires adherence to applicable policies, as well as review

and sign-off from internal legal, conflicts, tax, and accounting policy groups, among others, such as credit and market risk management. Transactions involving a special purpose vehicle receive special scrutiny and must comply with a special purpose vehicle policy

administered by a committee to ensure that every such entity is

properly approved, documented, and monitored.

The primary responsibility for adherence with all policies and

procedures, including those designed to address reputation risk,

lies with the business units conducting the transactions in question. But in addition to this framework, J.P. Morgan Chase in August of this year put in place a new set of procedures designed to

reinforce our focus on reputation risk and provide a senior level of

review of transactions with clients.

Business units are required to submit to regional policy review

committees proposed transactions that may raise reputation risks

for any reason, but specifically including transactions where a material objective is to achieve a particular accounting treatment,

those designed to achieve a particular tax treatment, those where

there may be material uncertainty about legal or regulatory treatment, those with highly complex structures or cash flow profiles,

and those which have as a significant purpose or effect the providing of financing, but which take the form of derivatives.

The members of the regional policy review committees, including

the Americas Committee, are senior representatives of the business

and the support units, including tax and accounting policies, in the

region. Transactions are reviewed from every angle that could affect reputation risk, but including specifically, where applicable,

the intended financial disclosure of the transaction by the client,

and the committee approves, rejects, or requires further clarification or changes in the transaction. These committees and their deliberations are overseen by a Policy Review Office, which I lead,

and transactions can be formally escalated by the committees to

me.

We at J.P. Morgan Chase believe that one of the tests of our

leadership in the financial marketplace is to learn from our experiences and to adjust our practices in light of these experiences and

the changing environment. The core lessons we have learned are,

one, that we cannot rely solely on our clients and their experts to

determine that our transactions with them will be properly accounted for and disclosed; two, that we need to make sure that our

transactions with clients are not misused to deceive investors or

others; and three, that even where these tests are met, we need to

consider carefully whether transactions could be viewed adversely

in a way that would be harmful to our reputation for integrity, fair

dealing, and doing first-class business in a first-class way.

I believe that the policy review process we have put in place and

which I have just outlined, together with our business transaction

approval policies and procedures, are well designed and are already

serving to enable us to meet these standards.

46

1The joint prepared statement of Mr. Traband, Mr. Peiffer, and Mr. Feldstein, appears in the

Appendix on page 107.

As a final note, I would add that as the biggest corporate lender

in America and as one of the largest investment managers, we

have as much interest as anyone in increased transparency and

disclosure and integrity in financial markets. We have our money

and our investment management clients’ money at risk in our belief that those financial statements are accurate.

I would, of course, be happy to respond to any questions the

Chairman or other Members of the Subcommittee may wish to put

to me regarding the policy review process. Thank you, Senator.

Senator LEVIN. Thank you very much, Mr. Patterson.

Mr. Traband, I believe you were going to proceed next.

TESTIMONY OF ROBERT W. TRABAND,1 VICE PRESIDENT, J.P.

MORGAN CHASE AND COMPANY, HOUSTON, TEXAS; ACCOMPANIED BY ERIC N. PEIFFER, VICE PRESIDENT, J.P. MORGAN

CHASE AND COMPANY, NEW YORK, NEW YORK

Mr. TRABAND. Thank you, Mr. Chairman. My name is Robert

Traband and I am currently a Vice President of J.P. Morgan Chase

Bank. I am making a joint statement on behalf of myself and Eric

Peiffer.

Let me say at the outset, Mr. Chairman, that while we believe

that our participation in the Fishtail and Flagstaff transactions

was perfectly legal and followed established rules, had we known

then what we know now about Enron’s practices, we would not

have engaged in these transactions with Enron. We would not have

accepted at face value, as we did in 2000 and 2001, Enron’s statements that its requests to structure Fishtail or Flagstaff in particular ways were designed to properly achieve Enron’s desired financial statement treatment of the transactions in accordance with

Generally Accepted Accounting Principles.

In addition, we would have wanted to know more about the aspects of the transactions in which the firm was not involved. But

at that time, we, like many other parties, dealt with Enron in the

belief that it was one of the most respected companies in America

and that it was not our role to second guess our counterparties’ accounting or other structuring determinations.

In the case of Enron, the firm suffered substantial injury, not

only by the loss of hundreds of millions of dollars from its own

transactions with Enron, but also from the injury to its reputation

from the erroneous suggestions of some that the firm was involved

in Enron’s wrongdoing. For these and many other reasons, we regret that we ever dealt with Enron.

Let me now turn to the specific transactions with respect to

which the Subcommittee has requested information from the firm.

The first of these transactions has been referred to by the Subcommittee and others as Fishtail. This transaction was a $41.5 million loan commitment extended by the firm in December 2000 to

a special purpose entity named Annapurna LLC, established by

Enron. This commitment expired by its terms in June 2001 and

was never funded.

47

Enron informed the firm that in anticipation of its ultimate contribution of the existing pulp and paper business to a joint venture,

Enron wanted to deconsolidate its pulp and paper business from

the rest of its businesses. Enron also told us that in consultation

with its accounting advisors, it had devised a structure to achieve

this objective. Enron would contribute its economic interests in the

present and future contracts of the pulp and paper business to a

newly formed entity, Fishtail, which would be jointly owned by

Enron and Annapurna.

As I have said, the firm’s participation in this transaction was

limited to a 6-month commitment to make a bank loan to

Annapurna. The firm had no other involvement in the transaction.

The decision to make a commitment to Annapurna was a reasonable credit decision and it is not at all unusual, as banks often

make loan commitments with the expectations that they will not

be funded.

The firm acted as a leader—a lender in this transaction and, consistent with industry practice, it did not make any determination

whether completion of the transaction would achieve Enron’s accounting objective, a deconsolidation of Enron’s pulp and paper

business. Such determinations were properly for Enron to make

with the advice and assistance of its internal accountants and external auditors. In this connection, I note that the Subcommittee

staff report states that Arthur Andersen actually did approve this

transaction.

In December 2000, when the Fishtail transaction was agreed to,

the firm had no reason to believe that any such determinations

were not being made by Enron and/or Arthur Andersen, which was

then one of the Nation’s premier accounting firms, in accordance

with Generally Accepted Accounting Principles.

There is one final point I would like to make about the Fishtail

transaction. It appears that Fishtail included a broader set of

transactions by Enron to effectuate not just the deconsolidation of

Enron’s pulp and paper trading business, but to recognize income

in connection with the sale of those assets. The firm was not involved in these other transactions, and indeed was told very little

about them by Enron or anyone else, for that matter.

The Subcommittee has also asked for information concerning the

firm’s understanding of and participation in the Slapshot project,

particularly with regard to the Flagstaff transaction. As I will explain in greater detail, Slapshot was the name given by the firm

to a generic form of transaction intended to permit a loan by a U.S.

lender to a Canadian borrower, to be structured in a manner that

would provide advantageous tax treatment to the Canadian borrower under Canadian law.

Flagstaff was the name under which a specific transaction with

Enron was undertaken in June 2001 to provide long-term refinancing for the acquisition of a Canadian pulp and paper mill,

Stadacona, acquired by a joint venture in which Enron was a equity participant. In short, Flagstaff was an actual transaction;

Slapshot was not.

As the Subcommittee is aware, there are substantial differences

in tax codes of other countries that taxpayers, including both individuals and businesses, may lawfully and properly take advantage

48

of. Such a situation existed under Canadian tax law, but before

proposing the transaction to any client, the firm’s structured finance group solicited and received a written opinion of an independent and highly regarded Canadian law firm setting forth the

likely tax consequences of that structure under Canadian law. Ultimately, the firm obtained written opinions from two leading Canadian law firms that the structure and the Canadian tax benefits it

provided were legal and valid.

As I have indicated, the Flagstaff transaction had its genesis in

the planned purchase of the Stadacona Canadian paper mill by

CPS, a Canadian corporation owned by a joint venture, Sundance,

between Enron and another party. The firm did not participate in

the formation of the Sundance joint venture. Documents shown to

employees by the firm by the Subcommittee staff during interviews

in preparation for this hearing reveal that there were many aspects

of the structure and funding of the joint venture that were completely unknown to us. Indeed, at the time of the Flagstaff transaction, the firm did not know the identity of Enron’s partner in the

joint venture.

In January 2001, representatives of the firm met with Enron to

present a proposal under which a group of banks would make a

loan to finance the acquisition of the mill. During the meeting, the

firm advised Enron that it had concluded, based on the opinion of

counsel, that the loan transaction could be structured in a manner

that would provide advantageous tax treatment to a Canadian borrower under Canadian law. Enron informed the firm’s representatives that Enron was aware of and had itself already devoted substantial attention to analyzing a substantially similar Canadian

tax structure.

Enron ultimately selected the firm to lead the bank group, but

opted to complete the acquisition of the Stadacona mill in March

2001 with a bridge loan of approximately $375 million provided by

Enron. The Flagstaff transaction was thereafter completed in June

2001 in order to repay the bridge loan and provide the long-term

debt financing. The Flagstaff loan transaction was structured in a

manner intended to permit the realization of the Canadian tax benefits by the Canadian borrowers. To the best of the firm’s knowledge, this structure did not provide otherwise unavailable U.S. tax

benefits to any party. We understand that Enron obtained and relied upon its own written opinion from Canadian tax counsel and

that the anticipated Canadian tax benefits could and should be realized under the structure.

As the Subcommittee is aware, the Flagstaff structure is highly

complex, and among the several transactions that comprise the

structure was an intraday loan of approximately $1 billion provided

by the firm to Flagstaff. It also involved two special purpose entities created by Enron or its affiliates. The complexity of the Flagstaff financing and the legal documentation required to implement

it was necessitated by Canadian tax considerations and were undertaken in reliance of the opinions of Canadian tax counsel to facilitate realization of the Canadian tax benefits.

As the Subcommittee also is aware, the credit support for the

loan was provided by Enron, principally through a total return

swap and certain supporting transactions, rather than as originally

49

1The joint prepared statement of Mr. Traband, Mr. Peiffer, and Mr. Feldstein, appears in the

Appendix on page 107.

contemplated, a guarantee by Enron. This change was specifically

requested by Enron. One or more members of our team understood

at the time that a principal reason for Enron’s position on this respect was that Enron had concluded that a guarantee might require consolidation of the entire Sundance joint venture, the assets

of which included CPS and the Stadacona mill.

The firm understood that the use of a total return swap to facilitate the continued deconsolidation of the joint venture had been

vetted by Enron with its external auditors, Arthur Andersen, and

had been approved by them. The firm did not attempt to second

guess this accounting judgment. As I have noted earlier, under applicable law and practice, each party is properly responsible to ensure that it correctly accounts for the transactions to which it is a

party. At the time, the firm had no reason to believe that any such

determinations were not being made by Enron and its external

auditors in accordance with Generally Accepted Accounting Principles.

Consequently, from the firm’s standpoint, the issue presented by

Enron’s decision not to provide a guarantee was whether the total

return swap provided sufficient credit support for Flagstaff loans,

that the new arrangement could prudently be accepted by the

banks in lieu of a direct Enron guarantee. Ultimately, we and the

other members of the bank group each concluded that the total return swap provided adequate credit support.

This concludes my statement, Mr. Chairman. I am happy to answer any questions.

Senator LEVIN. Mr. Peiffer, you are not going to give a statement

at this point?

Mr. PEIFFER. It was a joint statement on behalf of both of us.

Senator LEVIN. Mr. Feldstein.

TESTIMONY OF ANDREW T. FELDSTEIN,1 MANAGING DIRECTOR, CO-HEAD STRUCTURED PRODUCTS AND DERIVATIVES

MARKETING, J.P. MORGAN CHASE AND COMPANY, NEW

YORK, NEW YORK

Mr. FELDSTEIN. Thank you, Mr. Chairman. My name is Andrew

Feldstein. As Mr. Patterson said, I am a Managing Director at J.P.

Morgan Chase, and since March of this year, I have been the CoHead of our Structured Products and Derivatives Group in North

America. In addition, I work closely with Mr. Patterson on the

firm’s Policy Review Office, designing and implementing the policies to guard against participation in transactions that don’t comport with our standards for integrity and our commitment to transparent financial markets.

I would like to say four things. First, based on my review of the

facts from this Subcommittee’s report as well as from my internal

inquiries, I am convinced that neither Mr. Traband nor Mr. Peiffer

nor anyone else at J.P. Morgan Chase knowingly aided and abetted

Enron’s apparently deceptive activities.

Second, Mr. Chairman, you mentioned earlier today the need to

root out corruption in financial statement presentations. We agree

50

1 Exhibit No. 303(a) appears in the Appendix on page 190.

with you 110 percent. We think it is incumbent upon all participants in our capital markets to combat that type of conduct at

every turn. We are with you.

Third, what has changed? The processes that our firm has implemented and the culture that we are endeavoring to create at all

levels of the firm are meant to avoid our firm’s participation in

transactions contrary to the principles of integrity and transparency.

One thing in particular bears noting here. We now insist not only

everyone that works for me in structured finance, but everyone in

the firm, to ask questions, more questions, and more specific questions than were commonly asked 1 year ago. We no longer rely on

the assurances of clients or their outside advisors when the facts

and circumstances of proposed transactions should give us pause.

I like to think that senior management chose people like Mr. Patterson and me to play a big part in this cultural evolution because

we have the ability to be real thought leaders and we can work

with all professionals in the firm to identify the indicia of transactions that must be thoroughly questioned.

Finally, let me end with this. The fact that things are changing,

whether internally at firms like ours or with the accounting rules,

that is evidence of what is good in the U.S. capital markets. Participants join together with the encouragement of committees like

yours to help make the markets work even better.

I appreciate being given the opportunity to appear before you

today and I look forward to answering any questions. Thank you.

Senator LEVIN. Thank you all.

Mr. Peiffer, let me start with some questions to you. You worked,

as I understand it, on the implementation of the Slapshot deal and

the negotiations with Enron, is that correct?

Mr. PEIFFER. That is correct.

Senator LEVIN. As I indicated in my opening statement, I believe

the details of that structure show it to be a sham and I would like

to go through the $1 billion so-called loan that Chase, through an

SPE or special purpose entity that it created called Flagstaff, made

to the Enron special purpose entity called Hansen. The $1 billion that Chase sent to Flagstaff, which again was

under its control, was returned to it on the same day, as a matter

of fact, within a period of a few hours or even a few minutes, and

I want to look at some slides that show the general schematic of

the transaction.

First, step one. Chase provided a $1 billion so-called daylight

overdraft loan to Flagstaff, its own special purpose entity. That is

a loan which existed for just a few hours, if that long.

This is, I believe, Exhibit 303(a),1 if you want to take a look in

your book. It may be hard for you to see that far. So step one, at

the bottom right, a $1 billion loan from Chase to Chase’s special

purpose entity, Flagstaff. That is the daylight overdraft loan for the

few hours.

Step two, Enron gets the $1 billion daylight overdraft from

Citibank, runs the money through a few of Enron’s subsidiaries,

and puts it in an escrow account at Chase, and that escrow account

51

1 Exhibit No. 352 appears in the Appendix on page 525.

you will see there is called Newman and that is another Enron special purpose entity.

Step three, Flagstaff at that time, and only then, releases the Chase $1 billion and it goes through a number of Enron entities

to Citibank. So Citibank now has got its $1 billion back a few moments later. And then as soon as Flagstaff releases the Chase $1

billion, Newman releases the $1 billion from the escrow account to

Flagstaff and then back to Chase. Now, all of these transactions

occur within a matter of hours, some within a matter of minutes.

One billion dollars this way, a billion dollars, that way.

Exhibit 352 1 is the funds flow schedule that was attached to the

opinion of Enron’s tax counsel, who is also your tax counsel. Notations next to the funding steps show that certain steps will be completed by certain times, and it shows that the $1 billion would be

returned to Chase between 10 a.m. and 12 noon the same day that

it left Chase.

Chase released over $1 billion from its left hand, took the money

back with its right hand, and you designed the structure so that

even though $1 billion was returned almost instantaneously, at

least on the same day, there would be an appearance to Canadian

tax authorities that there was an outstanding loan of $1.4 billion. Now, Mr. Peiffer, isn’t it the case that the amount of the $1 billion, $1.039 billion to be precise, was mathematically derived to ensure that interest payments made on the $1.4 billion apparent loan

would equal the principal and interest payments on the $375 million loan?

Mr. PEIFFER. That is correct.

Senator LEVIN. So the $1.03 billion amount wasn’t derived from

some independent business need, it was simply the number required to make the tax transaction work, is that correct?

Mr. PEIFFER. It was the number required to make the tax transaction work as it was intended.

Senator LEVIN. Now, the company receiving the loan, the socalled loan, was Hansen, a Nova Scotia unlimited liability corporation which had been established by Enron. Do you know when

Hansen was incorporated?

Mr. PEIFFER. Where it was incorporated? I am sorry.

Senator LEVIN. When Hansen was incorporated.

Mr. PEIFFER. Nova Scotia, I believe.

Senator LEVIN. No, when, not where.

Mr. PEIFFER. I don’t know when it was incorporated.

Senator LEVIN. Well, I will tell you when it was formed, less than

2 weeks before this transaction took place. That was also the same

day that Newman, the company that formed the escrow account,

was created.

Given how new Hansen was, do you believe that it was a company with an identified business purpose that warranted a $1 billion loan?

Mr. PEIFFER. I think here, it depends on what context you are

defining business purpose.

Senator LEVIN. The normal.

Mr. PEIFFER. In my understanding——

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Senator LEVIN. Just normal understanding.

Mr. PEIFFER. My understanding is that Enron set up both Hansen and Newman to help effect this transaction and that for Canadian tax purposes, based on advice we and they received from our

Canadian tax counsel, that the contracts they entered into constituted a business purpose.

Senator LEVIN. So these were set up for this transaction, these

companies?

Mr. PEIFFER. That is my recollection, yes.

Senator LEVIN. What was the commercial business purpose that was associated with this $1 billion loan to Hansen?

Mr. PEIFFER. The loan to Hansen was actually $1.4 billion, and

as you——

Senator LEVIN. I want to talk about the $1 billion portion of it.

What was the commercial business purpose associated with that $1

billion, which was the majority of the $1.4 billion?

Mr. PEIFFER. I think it is hard to talk about, with all due respect, just the $1 billion portion, since it was one $1.4 billion loan.

I will acknowledge that, of course, as you did, that $1 billion came

from J.P. Morgan into Flagstaff and that J.P. Morgan was repaid

that same day, and so at the end of the day, there was $375 million

remaining in this joint venture.

Senator LEVIN. Which was the real loan, correct?

Mr. PEIFFER. Yes, the real loan, the economic loan is what I

would prefer to call it. However, if you look at the actual contracts,

there actually was a $1.4 billion loan. Those were actual contracts

that continue to be respected from a legal perspective to this day,

and in addition to that, from a Canadian tax perspective, which follows much more form over substance type of regime, my understanding, not being a Canadian tax lawyer, but given the advice

that we are given, that the Canadian tax advisers would respect

that as a $1.4 billion loan.

To answer specifically your question as to what the business purpose is, the business purpose of this transaction as a whole was to

provide financing to Enron in a tax advantageous way, and the $1

billion——

Senator LEVIN. Tax advantageous way——

Mr. PEIFFER [continuing]. And the $1 billion helped with that.

Senator LEVIN. That was the tax advantageous part of the $1.4

billion?

Mr. PEIFFER. I think the right way to say it is that it did help

with the making, of course, of the $1.4 billion loan, and that, taken

together with the other contracts, given the advice that we were

given from Canadian tax counsel, helped to generate the Canadian

tax benefits that were intended.

Senator LEVIN. But the $1 billion was the tax advantage portion,

was it not, of the $1.4 billion? That is what created the tax advantage.

Mr. PEIFFER. The $1 billion helped to create the tax advantage.

Senator LEVIN. Was there any other tax advantage, other than what was created by the $1 billion?

Mr. PEIFFER. There were only Canadian tax advantages gen- erated with respect to the full $1.4 billion loan interacting with the

other contracts.

53

Senator LEVIN. But I am saying, if it had just been the economic loan, as you put it, the business loan of $375 million, there would

not have been any tax advantage from that, would there?

Mr. PEIFFER. Right. I think it is fair to say that if it were only a $375 million loan, that Enron would have received tax deductions

on that $375 million loan and that is it.

Senator LEVIN. The interest on it?

Mr. PEIFFER. Yes.

Mr. FELDSTEIN. May I add something, Mr. Chairman?

Senator LEVIN. I would rather not. I want to just keep going with

Mr. Peiffer and then you can come in a little later, if you like. Mr. Peiffer, would Chase have approved the $1 billion loan, that portion of the $1.4 billion loan to Hansen, if it had not been assured that it would receive the money back immediately from an

escrow account held by Enron?

Mr. PEIFFER. I think it is fair to say it would not. From a credit

perspective, Chase obviously would be concerned about getting paid

back that amount of money, and so felt more comfortable if Enron

was either paying to us $1 billion first via a separate transaction,

and preferably through an escrow account, which I recall is what—

where Newman had the money prior to paying to Chase under the

subscription assumption agreement.

Senator LEVIN. So is it fair to say, then, that the $1 billion portion of that loan to Hansen would not have been made by Chase

unless you knew that there was money in escrow to immediately

pay that money back to you, is that fair?

Mr. PEIFFER. That is fair.

Senator LEVIN. Now, Mr. Peiffer, you are listed on the incorporation papers of Chase’s special purpose entity Flagstaff as Flagstaff’s

Vice President, and Mr. Traband, you are listed as the Treasurer

of Flagstaff. So as corporate officers of Flagstaff, both of you, with

fiduciary duty to the company, I take it that you would not have

felt comfortable loaning $1 billion to Hansen if you didn’t know

that the same amount of money was already in an established escrow physically located at Chase and that Chase would immediately receive the money back from Enron, is that a fair statement? You wouldn’t possibly be handing $1 billion out to this new

company without being darn sure that that $1 billion was coming

right back to you, is that fair to say?

Mr. PEIFFER. I think it is fair to say we would go to measures

to make sure that $1 billion was repaid.

Senator LEVIN. Mr. Traband, do you agree with that?

Mr. TRABAND. Yes. We understood the full scope of the transaction.

Senator LEVIN. Now, even though the $1 billion, then, of the socalled $1.4 billion was already returned, you have asserted that

the—Mr. Feldstein, did you want to interrupt at this point?

Mr. FELDSTEIN. No, I think I will wait.

Senator LEVIN. OK. Even though the $1 billion was already returned, you nonetheless have asserted in your testimony that the

tax deduction for interest on the entire $1.4 billion was allowed in

Canada, and Chase has put a great deal of emphasis on that assertion in its statements. I am aware that a Canadian law firm informed Chase that Slapshot would be acceptable. However, that

54

1 Exhibit No. 344 appears in the Appendix on page 396.

same law firm had provided services to Enron and told their client

that Slapshot was likely to attract scrutiny by Revenue Canada.

Were you aware of the fact that advice was given, by the same

lawyer who advised you, to Enron that this transaction would attract scrutiny by Revenue Canada, Mr. Peiffer?

Mr. PEIFFER. At the time of this transaction, I was not aware.

I have since become aware. But to comment on that, I don’t think

it necessarily would be surprising to say that this transaction or

any necessarily complex transaction with tax advantages would—

might invite some scrutiny.

Senator LEVIN. But you designed the structure to be hidden from

authorities, Canadian authorities. For example, Flagstaff, which is

your special purpose entity, was concerned because the $375 million that it received from the bank consortium had a different interest rate than the so-called $1.4 billion loan, so Chase could lose

money.

And so Enron and Chase considered alternatives to avoid that

risk, and Exhibit 344,1 if you will turn to that, contains a chart depicting various alternative strategies to alleviate Chase’s interest

rate risk. The chart on page 12 of that Exhibit 344 addresses alternative one under this section, entitled ‘‘Advantages.’’ Advantages—

there were three alternatives you were looking at to address your

interest rate risk, three alternatives.

Alternative one had the advantage of not having a road map for

Revenue Canada, and to read the exact words there, ‘‘No road map

for Revenue Canada. No swap by Enron on economic interest.’’

Now, a few pages later in Exhibit 344 is a chart that summarizes

all three alternatives. One of the advantages of alternative two—

excuse me, one of the disadvantages of alternative two is that it

leaves a potential road map. Do you see that on page 15, under alternative two, disadvantages?

Mr. PEIFFER. Yes, I do.

Senator LEVIN. Potential road map. Who does it leave a potential

road map for? That same Revenue Canada.

And then looking at the disadvantages listed for alternative

three, it lists under disadvantages, possible road map for Revenue

Canada with respect to these alternatives. So it clearly was your

design and your joint decision with Enron, is it not correct, that

you wanted to avoid providing a road map to Revenue Canada, is

that a fair statement?

Mr. PEIFFER. Well, what I think is unfair is to say that the transaction was designed to avoid scrutiny. I think with any tax advantaged transaction that any company would do, there is an inherent

desire to avoid highlighting the transaction. This, in particular, the

interest rate swap, I don’t think had on the margin very significant

ability to highlight or not highlight the transaction.

As you can see, there are a number of boxes and arrows, so to

speak, with the transaction. I think that if the transaction was to

be audited or not audited based on that, and to isolate it to the interest rate swap, I don’t believe was the case.

I mean, it was one of many advantages or disadvantages under

each alternative that we considered and Enron ultimately ended up

55

choosing the alternative based on whether it felt it could get comfortable with taking on additional fixed-rate interest rate exposure.

There was very little discussion as to the road map, and when

Enron actually chose that alternative, my recollection of the conversation was that it was based entirely on its ability to absorb additional fixed interest rate exposure and that there was no concern

or discussion about this potential road map issue that we are looking at here.

Senator LEVIN. Whether there was discussion of it or not, this is

a document that you used to pitch this particular approach, did you

not? Didn’t you design this? Wasn’t this a Chase design?

Mr. PEIFFER. I was not heavily involved at all in designing the

structure, as I am not a tax expert.

Senator LEVIN. Was it Chase’s design, though?

Mr. PEIFFER. It was Chase’s design, using a good deal of existing

technology, tax technology, let us call it, that existed and other tax

regimes where form took a great deal of place over substance.

Senator LEVIN. So in the Chase design, or its tax technology, as

you call it, you listed the advantages and disadvantages of each of

three approaches, and Chase listed an advantage of there not being

a road map to a potential customer, and listing alternatives two

and three having disadvantages of having potential road map or

possible road map. That is what you were pitching to a client here,

is that not correct?

Mr. PEIFFER. Well, at this point——

Senator LEVIN. Whether there was discussion of it or not, this is

your document, isn’t it?

Mr. PEIFFER. Right. This was an organizational meeting. It was

discussing the transaction, assuming that the transaction would go

forward. It is our document, but, again, it naturally would have

been this company’s preference to not highlight a transaction.

Senator LEVIN. Which company, yours or Enron’s, when you

say——

Mr. PEIFFER. Enron’s.

Senator LEVIN. Why would you want to not have a transaction

be apparent, or be transparent? Why would you want to try to sell

an advantage of an option as not being transparent to the tax folks

and to avoid giving them a road map? Why did you want to avoid

that? Why did you think Enron wanted to avoid that?

Mr. PEIFFER. I think it is customary that any company would

rather not highlight a transaction with tax advantages, given that

I think that the transaction itself would more or less highlight

itself were it to be looked at by Revenue Canada, and they certainly would.

Senator LEVIN. Well, if they were going to look at it anyway,

then you wouldn’t have to pitch the absence of a road map as being

an advantage, would you?

Mr. PEIFFER. In the end, there ended up being very little, if any,

discussion around this particular aspect of choosing the interest

rate swap precisely because of that.

Senator LEVIN. I am not so interested in whether there was a

discussion. I am much more interested in why Chase would design

a structure and make a pitch for one of the options as having the

advantage of being less transparent to the tax authorities. If you

56

1 Exhibit No. 344 appears in the Appendix on page 396.

have nothing to hide, it would seem to me that Enron would be

perfectly willing to share all the information with the tax authorities. They would not care if they gave it a road map or not.

Something was being hidden here by Enron. They didn’t want

this to come to the attention of the tax authorities. They had an

opinion, as a matter of fact, which you say you didn’t know about,

but they had an opinion from the tax lawyer who also gave you tax

advice on this transaction. The opinion from their tax lawyer and

yours, but you say only to Enron, was that this would be challenged, or might be challenged by tax authorities in Canada, and

then you went and pitched this deal to them on something that you

obviously thought would be attractive to them, which is that it

would not give a road map to the people that would challenge this

or might challenge this.

Mr. PEIFFER. With all due respect, the opinion that Blake Cassels wrote to Enron took place a good number of months after this

was put together, and so based on the opinion that we had, we believed, given the strength of the opinion, that even if it were challenged, that it was a strong transaction and that the tax benefits

inherent in it would stand.

Again, the interest rate swap was a very small aspect of this

transaction, and so to say whether it was not highlighted or not,

I think it is very difficult to extrapolate and say we are trying to

hide or even not highlight the entire transaction.

Senator LEVIN. That is not extrapolation. I am reading your document.1

Mr. PEIFFER. But with all due respect, this is a very small part

of the entire transaction, and to say——

Senator LEVIN. I am not extrapolating.

Mr. PEIFFER [continuing]. And to say on the margin that this is

what is hiding the transaction——

Senator LEVIN. Advantage No. 1, no road map. Advantage No. 2,

no swap fees. Advantage No. 3, most preferable alternative, Canadian tax perspective.

Mr. PEIFFER. That is—I am sorry.

Senator LEVIN. That is listed by you as advantage No. 1 for alternative No. 1. I am not reading something into this. I am reading

your words. That is advantage No. 1.

Mr. FELDSTEIN. May I say something that——

Senator LEVIN. Sure.

Mr. FELDSTEIN [continuing]. Maybe helps to make sense of this,

and if you will give me permission, I wanted to say something more

broadly. I will get to your questions about the swap transaction, at

least my impressions of what went on. But, as well, I wanted to

talk about the $1 billion which you mentioned previously.

So I want to start maybe with just some general comments on—

very brief, I promise—on transactions with big tax consequences

like this. I want to give you my impressions of the Slapshot deal

based, of course, on 20/20 hindsight, and I want to really briefly,

I promise, talk about what is different at our institution relative

to when this transaction was done.

57

So first, unlike in the United States, tax principles in some jurisdictions elevate the importance of the form of a transaction. Sometimes that helps taxpayers and sometimes it works to their detriment. It is usually accepted in these jurisdictions that taxpayers

are entitled to structure a business transaction in the most advantageous form for tax purposes. In fact, their shareholders might say

that companies are obligated to do that. So that is just general observation.

My second point, which is on this specific transaction, I, too, am

not a Canadian tax expert, but from what I have gleaned, from

what I have read, including the report and internal inquiries, I believe that the Canadian tax laws relevant to this transaction are

very formalistic. The business transaction, you described correctly,

was a $375 million borrowing. The form of the transaction, including the economic reality, what was an economic reality, the $1 billion flow of funds, if respected, including all the separate entities

and the separate instruments that were created under some very

formalistic Canadian tax laws, showed a $1.4 billion borrowing and

it was tax advantageous to do that and it was very formalistic.

My impressions of the swap, to get back to the questions you

were asking, is that it was also important, being a very formalistic

regime, to make the swap look like it was swapping the transactions that were trying to be respected as the form of the transaction, i.e., swapping the $1.4 billion transaction, not swapping

what the underlying business transaction was, which was the $375

million loan.

From the review I have done and from your report, I glean also

that the structures on this transaction received advice from Canadian tax counsel that the form should be respected. Tax counsel

didn’t say it was 100 percent certain, and generally, that is not a

condition for structuring deals with material tax consequences.

We know now, after the fact, that Enron received an opinion

from tax counsel, and you were right, it was the same tax counsel

that had previously represented Morgan, but my understanding in

talking with people is that it was at Enron’s request that we stop

using that counsel so they could because it was their regular tax

counsel. They received an opinion from that counsel on the specific

facts of this transaction that heavily caveated the advice. My understanding is that no one from J.P. Morgan Chase saw that

caveated opinion.

So that brings me to item No. three, which is what would we do

differently now, because I think we would do things differently.

First of all, we now insist on advice from our own internal corporate tax department, which is separate from the business unit,

an independent third party tax counsel of their choosing to give us

advice on the specific facts of any transaction. I presume that on

the specific facts of this transaction, given what we learned after

the fact about the opinion that Enron received, that we might have

had new and different information that may have—I was not there,

so I don’t know for sure, but that may have caused us to act differently in this case.

Senator LEVIN. Why would you have acted differently, only if you

had access to the legal opinion?

Mr. FELDSTEIN. Again, let me try to maybe——

58

Senator LEVIN. You said you might have acted differently. I am

trying to figure out why.

Mr. FELDSTEIN. Maybe I wasn’t——

Senator LEVIN. What would you have now that you didn’t have

then?

Mr. FELDSTEIN. I guess I didn’t explain it well enough. What we

didn’t do then, but we do now, is with respect to any transaction

with material tax consequences or transactions which appear to us

to have material tax consequences, we take that transaction and all

the specific actual facts of that transaction to our corporate tax

group, a completely separate group within the firm, not part of the

business unit. Based on the facts that we provide to the corporate

tax group, their review of them, but also the review of outside

counsel selected by the corporate tax group reviewing the specific

facts of the deal, we get advice on the strength of the tax consequences or the tax analysis of that specific transaction.

That step was not part of our policy when this transaction was

undertaken, so that as you pointed out, the opinion delivered to

Enron, not seen by us, caveated the original advice that J.P. Morgan Chase had received about the certainty of the tax consequences. It caveated it heavily.

I presume, I don’t know for certain, but I presume that if we had

engaged our corporate tax group, if the people working on the

transaction had engaged the corporate tax group and the corporate

tax group had engaged the outside counsel, independent outside

counsel that they would today, that J.P. Morgan Chase, as well as

Enron, based on the specific facts of the deal as it was structured,

would have received very heavily caveated advice about it. And if

that were the case, the fact that we received very heavily caveated

advice may have caused us to walk away from this transaction.

The big policy change, again, because maybe I didn’t express myself clearly the first time, is that all transactions of this nature,

and not just ones where we know explicitly there is a material tax

consequence, but ones that have certain indicia that lead us to presume that there are material tax consequences, there is a rule that

now everybody follows willingly to take that transaction, the specific facts of the transaction to the corporate tax group for independent advice.

Senator LEVIN. You very much hedged your statement. I think

the bottom line is, would Chase be pitching this deal today? This

is your design. This is your structure.

Mr. FELDSTEIN. Let me first——

Senator LEVIN. This isn’t something Enron cooked up. This is

something Chase cooked up. Would you be pitching this deal today?

Mr. FELDSTEIN. I think that is an excellent question.

Senator LEVIN. I appreciate your saying that, but let me just

have a clear answer. Would you be pitching this today?

Mr. FELDSTEIN. Let me answer it in two ways, first, specifically.

We don’t pitch this transaction today. Second, more generally——

Senator LEVIN. How would you pitch it today, given what you

know about it?

Mr. FELDSTEIN. We would not pitch it today, given what we

learned are the—we would not enter into this transaction the way

it was——

59

Senator LEVIN. Let us get to it. You designed this structure. It

is not entered into it.

Mr. FELDSTEIN. Let me——

Senator LEVIN. You designed the structure. Would you design a

structure like this today?

Mr. FELDSTEIN. I do not believe we would. I was not there at the

time, so I don’t know what went into designing this structure.

Senator LEVIN. That is why I am saying today. Would you design

this structure today?

Mr. FELDSTEIN. Let me talk more generally, then, about what we

do today that is different from what we did then in the design of

transactions and the marketing of transactions.

I would characterize the way the firm approached the business

last year as a product-out approach. That is, the firm would design

products like this and they would go and market those products to

clients. We have reoriented our approach. I would describe the approach today as a client-in approach.

As opposed to designing generic transactions that we market to

any number of clients who may or may not have the appropriate

situation for those transactions, we start from a specific client situation, understand what makes the most sense for that client, and

sometimes there are tax consequences to transactions where we advise clients to do things in a certain way to take—to create a transaction that most effectively—with the most effective tax consequences. But that is different from what I think the old orientation was, which was to design a transaction generically and market

it.

So on your specific question, I don’t think we would have done

this transaction today given the policies we have in place to understand more about it, and more generally, I don’t think we do business the way we did business then. As a business matter, we are

much more client-in as opposed to product-out.

Senator LEVIN. But putting that aside, generic change, client-in,

client-out, this is a structure, whether you design it or whether it

is designed by somebody else. Would you be using this structure

today?

Mr. FELDSTEIN. We don’t use this structure today, so it

wouldn’t——

Senator LEVIN. Based on what you know about this structure, I know you don’t, but would you use it, given its $1 billion fake appearance of a loan? Would you participate in this thing——

Mr. FELDSTEIN. Given the tax——

Mr. PATTERSON. Can I take a crack at that, Senator Levin?

Senator LEVIN. You folks helped to create the appearance of a

$1.4 billion loan. It wasn’t. It was an economic loan of less than

$400 million. The billion you handed with this hand got it back

with this hand. You helped them create an appearance which then,

as you knew it, allowed that—because you sold it—allowed that

company to claim an interest payment for the full amount of what

was really a payment of interest and principal. You knew you were

participating in that.

Now, you also knew that it might be recharacterized by the tax

authorities in Canada and you even took steps to what would happen if the jig was up, if they caught on, if they didn’t allow the inVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00075 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
60

terest payment on the $1.4 billion and they took that payment as

being payment of interest and principal. You even then went to the

lengths of deciding what would you do if Revenue Canada said,

hey, wait a minute. That is not a $1.4 billion loan. That is a $400

million loan and the repayments of it are payments of principal

and interest, not all interest. We are not going to give you a tax

deduction, Enron. You folks even worked with Enron on what you

would do then.

My question is, would you participate in this kind of a transaction now? I don’t care whether you design it or someone else designs it. You know what this transaction was. You know the details

of it. Would you participate in this transaction today? That is my

question.

Mr. PATTERSON. I think not. The result that you describe seems

quirky, but as Mr. Feldstein explained, there are some tax jurisdictions where form seems to triumph over substance. That is why we

rely on the advice of tax counsel in those jurisdictions before we go

ahead.

In this case, as Mr. Feldstein said, we didn’t consult the tax

counsel in the same way that we would today, and I won’t repeat

everything he described, but we would have our corporate tax department, which is charged with looking after the firm’s reputation

in these matters, get its own outside counsel and get an opinion

based on all the facts.

I do not know, because I am not a tax counsel, whether we would

get as clean an opinion today as would be necessary for us to go

forward. But even if we did, sir, as I mentioned in my opening

statement, beyond assuring compliance with all external requirements, including tax laws, even if we thought this one might work,

I personally, as head of the policy review function, would have to

take into account how this would look to the world if, as we always

have to assume, it would be publicly disclosed, and whether even

if it met all the legal requirements and passed muster under Canadian tax law, it would be difficult to explain and might adversely

affect our reputation. And on that basis, knowing what I know, I

would not market this structure today.

Senator LEVIN. Is this just a matter of how it looks to the world?

Is this just a matter of that? Isn’t there something rotten about

something which looks like a $1.4 billion loan which is a $400 million loan? Doesn’t that trouble you as a banker?

Mr. PATTERSON. Well, the public perception of it troubles me. If

you put the—what if we went to the Canadian tax authorities and

got an opinion from the Canadian tax authorities that it worked?

It would still look kind of quirky, but it would not be viewed in

Canada as rotten.

Senator LEVIN. Would you be willing to do what you did with

Enron back then in terms of figuring out, what are we going to do

if the Canadian tax authorities find out about this, despite your

lack of a road map, that they track it anyway, that they spend as

much time as this Subcommittee staff had to spend to figure out

what was really going on here, Canadian tax authorities, if they

did that, if they reached the same conclusion that this was more

than quirky, this is just simply misleading because you are pretending that there was $1.4 billion which was lent, when in fact

61

1 Exhibit No. 351 appears in the Appendix on page 514.

2 Exhibit No. 391 appears in the Appendix on page 1006.

it was only $375 million, and if they reached that conclusion, you

folks worked, and if you will take a look here at Exhibit 351,1 you

folks even had a recharacterization rider. You had a fallback. You

had a safety net here if they caught on and if they recharacterized

this.

This is your document. The rider attempts to recast any principal

paid in excess of 25 percent of the recharacterized loan as instead

being a loan to Chase, instead of from Chase. Here you have got

Enron. You are cooking up a deal. This is something you are pitching, you pitched.

Mr. PATTERSON. I actually think that was added by Enron to the

deal we pitched.

Senator LEVIN. All right. You accepted it.

Mr. PATTERSON. We accepted it, yes.

Senator LEVIN. You agreed to this rider, which says if they decide, if the Canadian authorities find out about it despite your lack

of a road map, if they find out about it, you agreed with Enron that

you would then retroactively recast this as a loan to Chase instead

of from Chase. One of the biggest banks in the world is being lent

money by a client. That is what you agreed to. Does that trouble

you, not just the appearance if it is made public, does that bother

you as a person, as a banker?

Mr. PATTERSON. Well, the fact that we borrow money from a client doesn’t bother me. It seems to me not surprising that one

would try to anticipate what we would do if the initially intended

tax results were rejected by the Canadian tax authorities. I assume

in that context, I don’t know, but I assume that the whole transaction would be transparent to the Canadian tax authorities at

that time, including the recharacterization, and they might accept

it or not accept it.

Senator LEVIN. Is there any way in just common sense understanding that that could accurately be characterized as a loan to

you?

Mr. PATTERSON. To be honest, I am not familiar enough with the

transaction to be able to answer that question.

Senator LEVIN. Well, think about it, would you, and give us an

answer for the record.2

Mr. PATTERSON. Whether——

Senator LEVIN. Would you do that? Would you give it a little

thought and give us an answer for the record?

Mr. PATTERSON. Whether it would be possible to characterize——

Senator LEVIN. Whether you think——

Mr. PATTERSON [continuing]. Recharacterize a transaction as a

loan to us?

Senator LEVIN. Whether you think that in any way could be fairly described as a loan from Enron to Chase.

Mr. PATTERSON. Happy to.

Senator LEVIN. My understanding, by the way, is that opinion

that came to Enron from the lawyers came within a couple days

of, what, the completion of the transaction. It wasn’t, as you indiVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00077 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
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1 Exhibit No. 351 appears in the Appendix on page 514.

cated, Mr. Peiffer, months later. It was just right around the transaction.

Mr. PEIFFER. My understanding——

Senator LEVIN. It is obvious Chase knew that there was a question about this. We might as well cut to the chase. It is obvious

that you knew that there could be a problem. Whether that same

tax lawyer gave you that advice that they gave Enron or not, you

knew it because you had worked out what would happen if the Canadian authorities decided that this wasn’t right. You worked that

out. So you knew that there could be a problem with this.

To that extent that you had a retroactive recharacterization to

turn something which was a loan from you into a loan to you, and

it is that recharacterization document which seems to me to speak

volumes.1 It may only be a page, but it speaks volumes. It speaks

about what Chase really believed. Whether you saw that opinion

that the Enron folks got from that same lawyer or not, you knew

there could be a problem.

Mr. PEIFFER. Could I make a comment on this?

Senator LEVIN. Please.

Mr. PEIFFER. Again, Enron came to us with this. We are not sure

why—actually, I can say I do know why Enron came to us with

this. In the event that the Canadian tax authorities would recharacterize this, or choose——

Senator LEVIN. Disallow it.

Mr. PEIFFER. Disallow, yes, choose to disallow it by choosing to

recharacterize it as a $375 million loan, Enron was concerned specifically in that situation, if that was, say, a 20, 25 percent chance

of that happening, which would be consistent with a ‘‘should’’ level

opinion, then they wanted to limit the specific downside with respect to withholding tax. They and their counsel thought that this

provision would have a chance of success with that. It is not something we came up with, nor was it something we even thought

made sense for Enron to put in that, and we voiced that opinion

to them.

Senator LEVIN. You agreed to it.

Mr. PEIFFER. We didn’t think it was needed.

Senator LEVIN. Did you agree to it?

Mr. PEIFFER. Because of our strong opinions and what we knew

their opinion to be, or that we thought it was going to be, but yes,

we agreed to it and it was something that Enron even amongst

themselves was deliberating. And so I think it would be incorrect

to mischaracterize this as saying this is a reflection of what everybody thought of the deal. I think this was a specific clause to recharacterize something specifically, withholding tax benefits, withholding tax that would need to be paid——

Senator LEVIN. Sure.

Mr. PEIFFER [continuing]. If the intended tax benefits were not

achieved, and my understanding——

Senator LEVIN. You agree——

Mr. PEIFFER [continuing]. With a lot of tax transactions, whether

in the United States, Canada, anywhere, is that there are proviVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00078 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
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sions to address certain things like that if the intended tax benefits

aren’t achieved.

Senator LEVIN. But Chase agreed to recharacterize something as

a loan to it instead of a loan from it in order to help Enron avoid

taxes.

Mr. PEIFFER. I think in order to, under the Canadian tax rules,

potentially avoid withholding taxes if the transaction were—if the

tax benefits with respect to the transaction were disallowed. That

doesn’t take away the strength of the opinions or what we or Enron

believed to be the high probability of the tax benefits.

Senator LEVIN. There is nothing to take away from those opin- ions, because you knew—Chase knew that this loan was not $1.4

billion. That much, we know you knew. You have acknowledged

that. You knew it was an economic loan of $400 million.

Mr. PEIFFER. It was an economic loan of $375 million——

Senator LEVIN. Three-hundred-and-seventy-five million.

Mr. PEIFFER [continuing]. For legal and Canadian tax purposes,

the advice we received is that it was, indeed, a $1.4 billion loan.

Senator LEVIN. And you also knew that it was going to be challenged or could be challenged, and you also then agreed with Enron

that if it were challenged, you would retroactively change its nature. You would recharacterize it so that Enron wouldn’t be hit

with taxes by Canada. You helped to perpetrate a fiction. You

helped them perpetrate a fiction, because there was no $1 billion

loan.

Mr. PEIFFER. I am sorry, I take exception with that.

Senator LEVIN. You might take exception——

Mr. PEIFFER. I don’t look at this as perpetrating a fiction.

Senator LEVIN. That is a fiction. There was no $1 billion lent to

them.

Mr. PEIFFER. We have opinions from Canadian tax counsel——

Senator LEVIN. Was $1 billion lent to them or not?

Mr. PEIFFER [continuing]. With that——

Senator LEVIN. Was $1 billion lent to them? I know there was

$375 million. I am not talking about that. Was there $1 billion

lent?

Mr. PEIFFER. There was a $1.4 billion loan made to the subsidiary of——

Senator LEVIN. Of which $1 billion was repaid within minutes,

is that——

Mr. PEIFFER. Under a separate contract, with money coming

from elsewhere in Enron.

Senator LEVIN. Separate contract, it was repaid within minutes,

wasn’t it?

Mr. PEIFFER. I think the distinction here again to make is that

Canada follows a very form over substance——

Senator LEVIN. I am not talking Canada. I am talking Chase,

your reputation, transparency. We hear lectures about transparency, that you are going to be transparent. I am not talking

about Canada. Canada will take care of itself. I am talking about

Chase. You knew that the $1 billion of the $1.4 billion came right

back to you, did you not? You knew that much.

Mr. PEIFFER. I knew $1 billion was coming back to us, that is

correct.

64

Senator LEVIN. Of that $1.4 billion.

Mr. PEIFFER. Money is fungible and it was two separate transactions and we were advised that the transaction as a whole should

be split up into two separate transactions, and yes, we did receive

$1 billion back.

Senator LEVIN. Did you get a legal opinion about this recharacterization?

Mr. PEIFFER. We did not——

Senator LEVIN. When you agreed to this——

Mr. PEIFFER. There was no need for Chase to.

Senator LEVIN. When you agreed to this, was there a legal opinion on this that Chase got?

Mr. PEIFFER. With respect to this, in the context of this, Chase

did not need to receive a legal opinion, but my understanding is

that Enron received advice from their Canadian tax counsel that

it might be advantageous to put this in there in the event that this

were audited and all the facts had become known and that there

is the potential that this might do something for them.

Senator LEVIN. You understood that Enron got an opinion from

its lawyers about this?

Mr. PEIFFER. Yes, I do.

Senator LEVIN. But you didn’t?

Mr. PEIFFER. We had an opinion based on the generic transaction, the generic structure——

Senator LEVIN. No, I know that——

Mr. PEIFFER [continuing]. But with respect to——

Senator LEVIN. The recharacterization.

Mr. FELDSTEIN. My understanding is J.P. Morgan Chase did not

get an opinion on the specific details of the transaction.

Mr. PEIFFER. Right.

Mr. FELDSTEIN. Today, we certainly would.

Senator LEVIN. Mr. Peiffer, you helped dream up Slapshot and

helped develop it. Were you rewarded in any way by your supervisors for this, any special way?

Mr. PEIFFER. I think it is fair to say?

Senator LEVIN. Was there a bonus, special bonus of any kind?

Did you get——

Mr. PEIFFER. There was no special bonus with respect to this. I

think it is fair to say that it was one of many elements that, you

know, played into the paying of a year-end bonus. We would all

have been much better off, I think, also, if we had never made any

of these loans to Enron and Enron had not gone bankrupt and the

bank had more money to pay the bonuses. We all would have been

better off if that were the case.

Senator LEVIN. Let me conclude by just saying this. You have got

some language on your website which says that banks were victims

in fraud cases, not accomplices. All I can tell you is this, that this

is a structure which you folks designed. You are not the victim

here. You designed a structure. You sold a structure. Part of the

sale was that it would not be providing a road map. You then

agreed if, in fact, the Canadian tax authority would find that was

not allowable, even agreed retroactively to recharacterize a loan

from you into a loan to you. You folks aren’t victims here.

Mr. FELDSTEIN. May I add something?

65

1 Exhibit No. 391 appears in the Appendix on page 1006.

2 Exhibit No. 369 appears in the Appendix on page 687.

Senator LEVIN. You folks helped a deceptive practice by Enron to

be perpetrated, and it is—I am glad you are changing your approach. I can’t tell you how glad I am. I will look forward, Mr. Patterson, to your answering the question for the record that you said

you would think about.1

But it is important that we all worry about how things look, and

that is important. But what is more important is how things really

are.

Mr. FELDSTEIN. Could I just address your comments about the

victim? My interpretation of that was that financial institutions

were the victims of deceptive accounting practices and disclosure

practices, or apparently deceptive practices at Enron. This transaction, and we have gone through the certainty or lack thereof in

terms of the tax consequences, but this had nothing to do with the

accounting presentation that Enron provided, but rather was a

transaction which rested upon whether Canadian tax law would respect the form in which it was structured, and the victim comment,

I think, is about the apparent accounting deception practiced by

Enron, which is a different subject, I believe.

Senator LEVIN. Your prepay pitch book back in 1998, if you look

at Exhibit 128, says the following. This is what you were pitching.

Prepayment received for a forward sale of inventory, fixed quantity,

specific delivery locations. Your third dot says, balance sheetfriendly. Is that still the kind of pitch you would make, balance

sheet-friendly, or balance sheet accurate? Which is more important?

Mr. FELDSTEIN. Balance sheet accurate.

Senator LEVIN. Is it fair to say, Mr. Patterson, you wouldn’t be

making a pitch quite like that anymore?

Mr. PATTERSON. I don’t have it and can’t see it, but——

Senator LEVIN. It is Exhibit 128.

Mr. PATTERSON. I don’t think we have No. 128 here.

Senator LEVIN. I am sorry, I have got the wrong number. It is

Exhibit 169.

Mr. PATTERSON. I don’t think we have that, either.

Senator LEVIN. Let me try again, Exhibit 369.2

Mr. PATTERSON. Three-sixty-nine. No, I think that we probably

would not use that terminology today. That doesn’t mean that accounting considerations are not relevant to our clients and to the

transactions they enter into. They are structured in a way to comply with accounting rules. So accounting considerations continue to

be an important part of structured finance. The key is that the accounting treatment be correct and not misleading.

Senator LEVIN. Thank you. Thank you all for your appearance

here today and we wish you good luck in greeting the weather on

your return home, and we also wish you good luck in implementing

fully and forcefully your new approach. It is important that our institutions, the ones we rely so heavily on, such as Chase and

Citibank and others that have been such an important part of this

economy, have the confidence and credibility of the public. I hope

66

1The prepared statement of Ms. Siebert appears in the Appendix on page 113.

your new guidance has an impact in that regard, both internally

and externally. Thank you all for coming.

Mr. PATTERSON. Thank you, Senator.

Mr. PEIFFER. Thank you.

Senator LEVIN. Ms. Siebert, we now welcome you, President and

Chair of Muriel Siebert and Company of New York. Ms. Siebert

gained fame as the first woman member of the New York Stock Exchange and Superintendent of Banks for the State of New York,

now an owner of a discount stock brokerage firm, one of our wise

elders—I hope you won’t mind that description—when it comes to

finance and the securities business. I want to thank you for your

travels here today from New York, also fighting the elements.

Pursuant to Rule 6, as I have mentioned to all of our witnesses,

our witnesses need to be sworn because of that rule of the Subcommittee, and so I would ask you to please stand and raise your

right hand.

Do you swear that the testimony that you will give before this

Subcommittee will be the truth, the whole truth, and nothing but

the truth, so help you, God?

Ms. SIEBERT. Yes, I do.

Senator LEVIN. Ms. Siebert, I think you have a statement, which

we would ask you now to proceed with.

TESTIMONY OF MURIEL SIEBERT,1 PRESIDENT AND CHAIR,

MURIEL SIEBERT AND COMPANY, INC., NEW YORK, NEW YORK

Ms. SIEBERT. Yes. I submitted a written statement, but I have

an abbreviated oral statement. I would like to thank you for inviting me. I am sorry I was late, but I came by way of LaGuardia Airport and then the train because they canceled our flights, so I

apologize for being late.

Senator LEVIN. Actually, you are right on time, except you

missed some testimony.

Ms. SIEBERT. Terrific. I commend your Subcommittee for tackling

this very tough, nasty job. You know, it will be 35 years ago that

I became the first woman member of the New York Stock Exchange, and at the time, while many people did not want me, I

joined a group where your word was your bond and you would go

broke before you broke your word. Things have changed when I

look at the Enron transactions. The money became too vast and it

was made too fast. I am sorry to say that greed became the creed.

Enron, in my opinion, represents a total moral bankruptcy. It

took more than the officers and the directors of the company. It required help from the accountants, the lawyers, and the investment

and commercial banks. Many people profited from these transactions, except the investing public, many of whom will never be

able to make their losses back. It has affected their future retirement and we have to make sure this does not happen again.

My interest in Enron really began in February. I received a call

from the man that runs our retail discount operations and he told

me that he was seeing things that he never saw before. We had clients selling out their entire portfolios and requesting a check. We

would not see that transaction if they sold their entire portfolios

67

and went into a money market fund. That would be an automatic

sweep. But when they requested a check, it took an action on their

part and our part.

I asked Peter, because we call every customer that leaves our

firm, and if it is because their nephew has gone to work for Merrill

Lynch, so be it. God bless them and good luck. If it is because of

something we have done wrong, I want to know about it.

So I started to get the reports every week, and the answer was,

don’t trust the integrity of the system. The system is against us.

We can’t let this happen. The reports have continued to come in

that way, although very few people compared to what we had before.

Our capital raising system is a national treasure. In the 1990’s,

the United States created tens of millions of new jobs. Every new

technological development was made in the United States, and for

most of the decade, at least the early part and middle part of the

1990’s, the market was orderly and the public, the small investors,

started to invest. First, they bought mutual funds. They wanted to

own a piece of America.

After I received the same answers for a few weeks, I realized the

seriousness of the abrupt change in our investors’ attitudes. Many

of them, when we called them, specifically mentioned Enron. Sure,

that was probably because there was a lot of publicity going on at

that time, but they had been hurt in bond funds and other products.

I will give you an example. When I gave a speech for the Miami

Herald at their yearly investors’ conference, a man in his 80’s during the question and answer period told me, ‘‘I lost a third of my

money. Will they go to jail?’’ This is serious.

Enron could not have happened without two new financial products, derivatives and structured finance. These products in themselves are not bad. It was the purpose that was employed that was

terribly wrong. They were used to deceive. The financial engineering permitted operations by legal loophole.

Derivatives are not new. I testified in 1988, I have it here, after

the 1987 market break. That was portfolio insurance. The regulators passed some laws and portfolio insurance is finished.

I testified in 1998, 10 years later, after long-term capital market.

Our country, frankly, lucked out in Long-Term Capital Management. Bob Rubin was our Secretary of Treasury and he was the

only Secretary of Treasury that has ever come from the trading

desks. He had helped invent derivatives. He knew what to do.

Long-Term Capital Management had an equity, it is reported, of $4

to $5 billion and they were carrying, using derivatives, the notional

value was over $1 trillion. When they made the wrong bet, major

margin calls were threatened. The Federal Reserve called in the

firms downtown. They called in the banks and they put together

money and they took over the operations of Long-Term Capital

Management and we liquidated it in a way that the public was not

hurt.

When I continued to see the attitude of our individual investors,

in late spring, I said, well, I had better go down to Washington and

tell some people what I am seeing, because I had never seen this

before. So I had lunch with Larry Lindsey. I had a telephone apVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00083 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
68

pointment with Secretary O’Neill and I spent time with Mr. Pitt

and his deputies. I recommended three things.

Under Sarbanes-Oxley, officers of corporations must certify the

authenticity of the earnings reports. I recommend that we add a

statement to those reports that these figures represent economic

reality. That would eliminate the sham transactions. That would

have eliminated the phony energy trades. No officer would sign a

statement that the transactions that your Subcommittee is examining represented economic reality.

Enron was the leader in energy trading when it became deregulated. They used legal loopholes to create an illusion of activity.

The trading practices of buying and selling on the same day, the

same amount, at the same price, are illegal. They are considered

to be wash sales in the listed markets. In the over-the-counter markets, they were legal. Other formerly solid conservative utilities

participated in these trades, which are still being unraveled. As a

result, some of these utilities have had to reduce or suspend their

dividends. Most of these stocks are owned by individuals who count

on the dividends for their livelihood.

In some cases, the price of some of these utility stocks have been

cut in half very fast, literally overnight.

Now, when companies issue debt, they have an indenture which

spell out the terms that these bonds are being issued under. It is

their covenants, for example, the ratio of interest coverage, the

ratio of asset coverage, the rating of bonds by rating agencies. If

these covenants are violated, they have debt triggers in there

whereby certain things are triggered. They can force a company to

repay the bonds immediately. It is very difficult for individuals or

institutional investors to get the terms of these bonds. They would

not have owned a lot of these securities had these terms been readily available.

I recommend that the debt triggers and terms of indentures on

bonds, as well as covenants or terms in the preferred stocks, be

made available easily and be listed on the corporation’s website so

that anyone who takes the effort, who wants to invest money, I do

not care if it is 100 share of a Duke preferred stock or a Dominion

preferred stock, can see the terms and see under what circumstances their income might be stopped or they will lose their

protection.

Finance is now global. It is almost impossible for regulators to

keep up with the fast-moving technology. The SEC and Federal

and State regulators, bank regulators, together could identify these

transactions if the information was furnished. Otherwise, it is very

hard for them to get into this. The SEC could have identified it.

The Federal bank and the State bank regulators could have identified some of these transactions. It is difficult for U.S. regulators to

act unilaterally. It will have the effect of driving the business offshore, but will not stop the business.

We know we are going to have global bank regulations. We have

some now. We will have global accounting standards. I suggest that

our country be the leader to establish global securities regulations,

that we include derivatives and margin requirements and other

things that are used to get around the purpose of the laws.

69

Certain laws and regulations have been passed which will stop

the same practices from occurring again, but we must make sure

that our focus is on the individual investor also, and that it is

geared towards reinstating their faith in the system.

Thank you for inviting me and allowing me to participate.

Senator LEVIN. Thank you very much, Ms. Siebert, for your very

thoughtful testimony.

I don’t know how much of the testimony this morning you were

here to hear. I know you had to take a train when you expected

to fly, but I think you have had an opportunity to look at the transactions which we were discussing here this morning in the report

of our staff. What is your reaction to those transactions that you

read about in our report?

Ms. SIEBERT. They were designed to deceive. They were designed

to create the illusion of certain economic events. I do not see the

economic reality for it.

Senator LEVIN. I think your testimony probably answered this

question, but I will ask it, in effect, again. Are these the types of

transactions that we want our major banks not only participating

in, but designing and selling to public companies and to other clients?

Ms. SIEBERT. No, they are not the kind of transactions, and I

would also say that if they do participate in those kind of transactions, they should not have the benefit of FDIC insurance.

Senator LEVIN. We are going to be hearing from our regulators

in our next panel and we want to find out what is being done to

stop this kind of deceptive practice, and I am wondering whether

you would agree that our regulators need to not only take enforcement actions on a case-by-case basis to punish wrongdoers, but also

to construct a regulatory deterrence program to deter future wrongdoing.

Ms. SIEBERT. I believe they can do it. Our regulators are really

a top quality group. The Federal Reserve and Federal bank regulators, the State bank regulators, the SEC, they have dedicated

staff there. I mean, it is wonderful to see them. But I also believe

that the information must be furnished them so they don’t have to

go hunting for it.

Senator LEVIN. And if that information is furnished for them, or

to them, excuse me, would it be useful if they can design, as you

put it in your testimony, acting together with the SEC and the

bank regulators acting together to regulate the kind of transactions

which we have heard about and talked about here at this Subcommittee.

Ms. SIEBERT. I believe it is. For a long time, I have said that we

need regulation by function, because investment banks are doing

the job previously done by banks and banks are doing the job previously done by investment firms. So they will have to work together. Normally, I don’t like to see Uncle Sam and the regulators

get too big, but it is probably the only way where we can effectively

put our arms around this problem.

Senator LEVIN. And in terms of the information that you say is

so important for them to have so that they can act, would you feel

it would be helpful if the SEC and the bank regulators conducted

a comprehensive joint review of these structured finance products

70

which are being sold by or used by our financial institutions so that

they could identify the ones that are designed to deceive?

Ms. SIEBERT. Yes, I believe that would be very welcome and necessary.

Senator LEVIN. Our thanks again. You are a frequent visitor to

committees of the Congress, to be providing the kind of testimony

which comes from your experience and we are very grateful for

that testimony and for your experience, for what you bring to the

world in which you spend a great deal of your time.

Ms. SIEBERT. I believe in the system. It has been very good to

a lot of us.

Senator LEVIN. It has, and we are going to do everything we can

to make sure that system is strengthened and that credibility in it

is restored, and it is going to take, I believe, at least, a combination

of the entities, the institutions, the financial folks acting on their

own to clean house, but it also is going to take a stronger regulatory arm, and we are going to talk to our regulators right now

and see whether they are in agreement with that. Thank you

again.

Ms. SIEBERT. That is great. Thank you.

Senator LEVIN. Let me now introduce our final panel of witnesses

who represent one of the most important pieces to this puzzle and

that is our regulators. We not only thank you for making it—I don’t

think you came quite as far as our other witnesses, but you have

waited longer. I hope that it was worthwhile to you in terms of the

testimony that you heard here. It is a very complicated subject that

you live with and we are dealing with and we have spent a lot of

time attempting to understand it and our staff has spent a huge

amount of their time putting together a staff report, which I think

has been made available to you.

We have at our witness table today Richard Spillenkothen, Director of the Division of Banking Supervision and Regulation at the

Federal Reserve. I think Ms. Annette Nazareth is on her way. She

is the Director of the Division of Market Regulation at the Securities and Exchange Commission. And Douglas Roeder, Senior Deputy Comptroller for Large Bank Supervision at the Office of the

Comptroller of the Currency.

This is a very distinguished panel. We know that they are involved in a lot of things and had to sort out their schedule to make

it possible to be here today. We look forward to hearing your views.

As I have indicated, pursuant to Rule 6 of this Subcommittee, all

witnesses who testify before us are required to be sworn, and at

this time, then, I would ask you to stand and raise your right hand.

Do you swear that the testimony that you will give before this

Subcommittee today will be the truth, the whole truth, and nothing

but the truth, so help you, God?

Mr. SPILLENKOTHEN. I do.

Mr. ROEDER. I do.

Senator LEVIN. I think, Mr. Spillenkothen, we are going to call

on you first.

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1The prepared statement of Mr. Spillenkothen appears in the Appendix on page 117.

TESTIMONY OF RICHARD SPILLENKOTHEN,1 DIRECTOR, DIVISION OF BANKING SUPERVISION AND REGULATION, THE

FEDERAL RESERVE, WASHINGTON, DC

Mr. SPILLENKOTHEN. Thank you, Mr. Chairman, for the opportunity to testify on the continuing efforts of the Federal Reserve

Supervisors to address issues emanating from the excesses of the

recent credit cycle, including large corporate defaults and accounting irregularities.

The focus of today’s hearing, on how complex structured financial

products provided by banks and other financial institutions were

used by their customers to obscure financial statements or to engage in questionable tax strategies, is timely. Events of the past

year, such as the bankruptcy of Enron, have focused attention on

the need for strong risk management, sound accounting, improved

disclosures, and more active corporate governance oversight to

avoid the kinds of losses that have been costly both in very real

human and economic terms.

The Federal Reserve has been reviewing bank participation in

the types of structured financial activities that have raised significant legal and accounting questions and I will discuss the status

of our efforts in a moment. I will also briefly discuss both our supervisory expectations for banks involved in transactions such as

those that have been the focus of this Subcommittee, as well as

how we are considering amending our procedures and refocusing

our supervisory reviews.

But first, I would like to say a word about the role of bank supervisors. The primary focus of the Federal Reserve’s supervision is

ensuring an institution’s overall safety and soundness, as well as

compliance with banking and consumer laws and regulations in a

way that protects the Deposit Insurance Fund and the consumer

while promoting stability of the financial system. As part of this

risk-based approach to supervision, examiners focus primarily on

areas posing the greatest risk to the institution, primarily credit

risk, market liquidity, legal, and reputation.

In carrying out our responsibilities, the Federal Reserve coordinates its supervisory activities with other Federal and State banking and securities agencies, such as my colleagues here from the

OCC and the SEC, other functional regulators, and the bank regulatory agencies of other nations. If in the course of their review examiners have reason to believe that a bank is engaging in questionable activities that might relate to a possible violation of securities

laws, then supervisors would refer those matters to the SEC as the

primary interpreter and enforcer of those laws.

I would say for an example, recently, Federal Reserve supervisors identified transactions by a banking organization, not one

the subject of these discussions, but by a banking organization that

raised concerns regarding the bank’s accounting and public disclosure. In this case, we referred those potential securities law violations to the SEC, and in coordination with the SEC and the bank’s

primary regulator, took enforcement action and remedial action in

a coordinated fashion.

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Now, some basic principles and expectations for banking organizations guide our work in examining complex financial transactions. First and most obviously, banks must obey the law. In particular, they must have policies and procedures in place to ensure

that they are in compliance with all applicable laws and regulations with regard to a particular activity or product.

Second, banks should perform thorough due diligence on the

transactions they are engaged in or involved in and check with appropriate legal, accounting, and tax authorities within their own

organizations, as well as their outside experts when appropriate,

and also provide appropriate and relevant information to their customers. However, banks ordinarily should not be held legally responsible for the judgments and actions or malfeasance of their

customers. Such an expectation would require, inappropriately, in

my judgment, banking organizations to assume management responsibility for their customers and also could place undue significant costs on banking organizations to audit the activities of their

customers. However, banks must not participate in activities of

their customers that the banks know to be illegal or improper, nor

should banks engage in borderline transactions that are likely to

result in significant reputational or operational risks to the banks.

Third, the role of banks is to assume and manage all the attendant risks related to their activities as financial intermediaries. In

light of recent events, banking organizations should be, and indeed

are, reevaluating the risks related to both their traditional as well

as their new products, recognizing that as financial markets and

practices change, legal and reputational risks may manifest themselves in new ways or in new magnitudes not previously recognized.

As part of our supervisory review of complex structured transactions, we are assembling and evaluating the various findings and

observations of our examiners, as well as the conclusions of other

primary and functional regulators we work with, and identifying

any necessary follow-up. While I am unable to discuss ongoing Federal Reserve supervisory reviews, as you know, there are several

transactions that are currently under investigation by the SEC and

other enforcement agencies with whom we have strong working relationships and with whom we have conferred on these matters.

We are continuing to collaborate with them and receive their views

and conclusions on various matters on an ongoing basis. As our fact

finding is completed and our conclusions are drawn, we will provide institutions with feedback on any identified weaknesses, and

if warranted, take appropriate supervisory corrective actions, including referrals to other authorities.

More generally, in light of recent events, we have already modified our examination plans for larger banking organizations to

focus more fully on evaluating the largest customer relationships,

that is, the large relationship with the customers that they have

and also looking at the overall customer relationship, not just a

transaction-by-transaction basis. These plans or examinations cover

the specific areas of concern in the structured finance business and

an evaluation of the steps banks are taking to manage the credit,

legal, and reputational risks in response to events of the past year.

We will also be looking at the new product review process and how

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1The prepared statement of Mr. Roeder appears in the Appendix on page 123.

they manage the real and reputational risks in the new product review process.

We have already begun the process of modifying our examination

guidance and are considering additional supervisory guidance or

regulatory changes, especially in the area of structured finance,

and if we do this, we will obviously work with our colleagues from

the other banking agencies and, as appropriate, the SEC.

In this connection, we will also evaluate the range of reforms

banking organizations are adopting, and once we are able to observe their performance and practice, consider whether there are

some sound practices that should be adopted more widely within

the industry.

In closing, the fallout from the recent round of excesses and large

corporate defaults appears to be resulting in some positive steps by

corporations, banks, and capital markets. Supervisors should play

a positive leadership role and work to ensure that these corrective

actions, that their ongoing supervisory activities reinforce these

corrective steps and help them to endure over the longer term. If

banking organizations, corporations, and supervisors are attentive

to the lessons learned over the past year and adopt appropriate

policies and controls, the risk of repeating similar excesses in the

coming years should be substantially reduced. Thank you.

Senator LEVIN. Thank you very much, Mr. Spillenkothen. Mr.

Roeder.

TESTIMONY OF DOUGLAS W. ROEDER,1 SENIOR DEPUTY

COMPTROLLER FOR LARGE BANK SUPERVISION, OFFICE OF

THE COMPTROLLER OF THE CURRENCY, WASHINGTON, DC.

Mr. ROEDER. Thank you. Chairman Levin, thank you for inviting

the OCC to participate in these important hearings. I am Douglas

Roeder, Senior Deputy Comptroller for Large Bank Supervision.

Let me begin by commending the Subcommittee for holding these

hearings. Enron’s failure has been nothing short of a national tragedy, especially for the thousands of Enron employees who lost their

jobs and retirement savings. At its height, Enron was a multi-billion-dollar corporation whose influence was wide ranging and far

reaching. Inevitably, some of its business involved national banks

which operate under OCC supervision. In my statement, I would

like to focus on the steps that national banks and the OCC as their

supervisor are taking to help prevent Enrons from occurring, future

Enrons.

The OCC is responsible for supervising over 2,000 banks, some

of which are the largest in the world. Resident examiners working

in these large banks use a risk-based approach to supervision, an

approach that takes into account the various sources of risk to a

bank. Because credit risk has traditionally posed the greatest

threat to safety and soundness of banks, much of our supervisory

attention has traditionally focused on credit issues. However, the

Enron situation demonstrates just how significant other types of

risk can be. As a result, we have asked ourselves how our current

approach could be enhanced.

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First, we intend to focus more intently on banks’ procedures for

authorizing new products. Our examiners will evaluate the bank’s

system to ensure that a comprehensive process exists for senior

managers to review and approve new product offerings. Also, we

believe it is important that the new product approval process is

sufficiently robust to capture even seemingly small changes that

could transform an existing product into one that poses an entirely

different degree or type of risk. When in doubt as to whether a

product requires vetting through the new product approval process,

we encourage bank management to take a conservative approach

and to apply the process to the proposed product or activity.

Going forward, we will sample more extensively transactions

going through the banks’ new product approval process. In particular, we will check to see whether banks are complying with

their own processes and whether proper review and authorization

are received prior to engaging in complex structured transactions.

In addition, we are in the midst of discussions with the other

banking agencies to determine whether interagency guidelines

should be revised to more specifically address board and senior

management responsibilities for the approval and oversight of new

products, such as complex structured products.

Second, while banks’ board and senior management may place

their stamp of approval on a new product, the bank must also carefully consider the appropriateness of complex structured transactions from the standpoint of the bank’s client. This represents a

shift in our approach into supervising such transactions. In the

past, our focus has been on how well the bank assesses the sophistication of the customer and that customer’s ability to perform

under the terms of the contract. We will now ask our examiners,

in addition, to determine whether bank management understands

the customer’s disclosure and accounting intent.

While it is not realistic for banks to be held responsible for how

customers account for transactions on their own financial statements, it is incumbent on bank management to carefully consider

the potential impact of their actions on the bank and to decline to

participate in transactions that do not meet the standards of integrity that the bank has established.

Third, we plan to review large relationships, even if credit risk

is low, and flag structured products during our credit work for potential further review. We think it is important that bank management establishes controls that encompass the bank’s total relationship with its large customers. Competitive pressures are a natural

part of any business environment, but care must be taken to ensure that line managers eager to retain or expand business with

important customers don’t cross the line and jeopardize the trust

and credibility that forms the foundation of a bank.

It is encouraging to report that banks are studying and learning

from the Enron experience, whether or not that experience was

firsthand. Banks that offer complex structured transactions have

come to realize that they stand to suffer great harm if they are implicated in questionable activities conducted by their customers. As

a result, banks have taken steps to improve their internal controls

of complex structured transactions and special purpose entities.

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1The prepared statement of Ms. Nazareth appears int he Appendix on page 134.

Some banks have made changes to management, establishing

new oversight committees, developing new policies and procedures,

tightening controls, upgrading internal reporting to management

and the board, and improving the quality and quantity of disclosures. Banks have also strengthened their review and approval

processes for complex structured transactions. This includes expanding the definition of products to be approved and enhancing

the approval process to provide for a broader range of senior-level

management review. Also, banks are putting a greater focus on assessing customer motivation and appropriateness, including securing representations from customers regarding disclosures and accounting treatment.

We believe that these are all positive steps toward strengthening

internal processes. We are currently evaluating the responses of

national banks and will assess these reforms as they are implemented.

I also want to highlight another important facet of the supervisory process. That is the interaction among the Federal regulatory agencies. The ability to make and receive referrals ensures

that the agency with the appropriate authority and expertise is involved. We are coordinating our reviews of national banks’ previous

involvement with Enron with the Federal Reserve and the SEC.

Because this is an open matter, I am unable to comment institution

specific details that pertain to the current reviews underway.

Thank you once again for inviting OCC to testify at this important hearing.

Senator LEVIN. Thank you very much, Mr. Roeder.

Let me welcome Ms. Nazareth. We know that you were late, tied

up somewhere, but we are going to need now to swear you in as

we do all of our witnesses, so I would ask you to stand and raise

your right hand.

Do you solemnly swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and

nothing but the truth, so help you, God?

Ms. NAZARETH. I do.

Senator LEVIN. Thank you. Ms. Nazareth, thank you.

TESTIMONY OF ANNETTE NAZARETH,1 DIRECTOR, DIVISION

OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE

COMMISSION, WASHINGTON, DC

Ms. NAZARETH. Thank you, and I apologize for being late, Mr.

Chairman. My name is Annette Nazareth and I am the Director of

the Division of Market Regulation at the Securities and Exchange

Commission. I would like to submit my written testimony for the

record and briefly summarize, if I may.

Senator LEVIN. Thank you, and it will be made part of the

record.

Ms. NAZARETH. Thank you. I will take just a few minutes to

highlight a couple of key points. First, the SEC has significant powers to investigate possible violations of the Federal securities laws

and to enforce those laws through civil and administrative actions.

The Commission to date has charged two former Enron officers

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with fraud based on their participation in transactions designed to

mislead investors about Enron’s financial results. The Commission’s investigation is ongoing and the Commission’s Division of

Enforcement continues to work diligently and vigorously with the

Justice Department’s Enron Task Force to ensure that all those responsible answer for their misdeeds.

While I cannot speak publicly regarding the specifics of any ongoing investigation, several aspects of the Commission’s general enforcement authority are particularly relevant to the issues of disclosure and transparency that are at the root of the problems you are

examining today.

The Commission has clear authority to proceed against public

companies that file false information as part of their financial

statements. Such conduct is potentially subject to various provisions of the Federal securities laws, including the requirement that

companies’ filings with the SEC be materially complete and accurate and the SEC’s general anti-fraud authority.

The Commission brings numerous actions, 163 this past fiscal

year, based on false and fraudulent financial reporting and disclosures. Among these was an action the Commission recently brought

against a public company for, among other things, using an undisclosed off-balance-sheet special purpose entity to dramatically overstate the company’s cash flow from operations. Cases like this

make clear that public companies using off-balance-sheet special

purpose entities must ensure not only that their accounting treatment compiles with Generally Accepted Accounting Principles,

known as GAAP, but also that they have accurately portrayed the

economic realities of the transaction.

The Commission also has explicit statutory authority not only to

proceed against primary violators of the Federal securities laws,

but also against aiders and abetters of those violations. The Commission aggressively employs this authority. In addition, the Commission may order any person who is or was a cause of a violation

of any provision of the Exchange Act due to an act or omission the

person knew or should have known would contribute to the violation, to cease and desist from causing such violations.

Aggressive enforcement not only punishes wrongdoers, but also

helps deter future illegal behavior, and in fulfilling this mission,

the Commission cooperates with the Federal bank regulators,

among others. The SEC obtains evidence of possible violations of

the securities laws from many sources, including from other regulatory authorities, such as the Federal bank regulators. In addition,

when appropriate, the Commission coordinates its investigations

with Federal banking regulators, which can result in coordinated

regulatory settlements.

For example, in a recent case, the SEC took action with respect

to accounting improprieties of the PNC Financial Services Group,

Inc., a bank holding company. The Commission’s order found,

among other things, that PNC materially overstated its earnings

by failing to consolidate into its financial statements three special

purpose entities to which it transferred approximately $762 million

of volatile, troubled, or under-performing loans and venture capital

assets. Based in part on this conduct, the Commission found that

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PNC had violated the anti-fraud record keeping and reporting provisions of the securities laws.

At the same time the Commission’s order was issued, the Federal

Reserve announced that PNC had entered into a written agreement

to address bank supervisory matters. The Commission acknowledged the substantial cooperation provided by the board in this

matter.

The Commission has long recognized the need to consult and coordinate with the Federal banking agencies on matters involving financial institutions that are public companies. For example, the

chief accountants of the Commission and the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the

Comptroller of the Currency, and the Office of Thrift Supervision

meet periodically to discuss matters of mutual interest. Similarly,

key decision makers meet regularly to implement supervisory programs, work on international agreements, and guard against

money laundering.

While our enforcement activities are ongoing, there are numerous other efforts underway at the Commission to improve the quality of reported financial information, the reliability of that information, and the timeliness of that information. The fall of Enron,

along with other corporate scandals, has crystallized the importance of efforts to strengthen the accountability of public company

officers as well as other so-called gatekeepers of our financial markets, the lawyers, the accountants, the auditors who work with

public companies as part of the financial reporting process. Enactment of the Sarbanes-Oxley law also will help ensure that regulation with regard to these parties is stronger.

Some of these regulations are already final. For example, as of

August of this year, the CEOs and CFOs are now required to certify the financial and other information in issuers’ quarterly and

annual reports. Other rules to implement the Act are proposed and

are on track to be finalized in January. For example, in November,

the Commission proposed rules regarding standards of professional

conduct for attorneys, and in October, the Commission proposed

rules that would significantly tighten the requirements for companies to disclose non-GAAP financial measures and for corporate

management to disclose material off-balance-sheet arrangements.

Individually and in their totality, these rules should have a significant effect on the quality and reliability of financial reporting and,

thus, should serve to enhance investor confidence.

At the same time that we are working to strengthen our own

rules and regulations, we are also diligently exercising our oversight role through our Office of Chief Accountant to make sure that

the private sector’s standard-setting bodies, including the FASB

and the AICPA, are making improvements in their auditing and

accounting standards. You will find the details of these improvements outlined in my written testimony.

To conclude, Mr. Chairman, there is no question that as we continue to unravel the improprieties of the Enron scandal and others,

we will take away many more important lessons, and in response

to these lessons, we will continue to refine our internal procedures,

cooperate with other regulatory bodies, and hone our rules and regVerDate 11-MAY-2000 10:41 Apr 28, 2003 Jkt 000000 PO 00000 Frm 00093 Fmt 6633 Sfmt 6633 83485.TXT SAFFAIRS PsN: SAFFAIRS
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ulations so that Enron-type disasters are less likely to occur in the

future. Thank you.

Senator LEVIN. Thank you, Ms. Nazareth.

We have seen in a number of transactions financial institutions

participating, aiding and abetting, contributing to deceptive prepays which were constructed to look like energy trades instead of

debt, deceptive asset sales that are backed by secret guarantees,

ensuring that the buyer will get its money back when the asset is

sold a second time, deceptive joint ventures that are formed to

move assets off balance sheets but ensure that the second investor

never has any funds at risk, and deceptive tax products that include fake business transactions.

I know that each of you, because you are leaders in your field,

are troubled by those kinds of deceptive transactions and, indeed,

spend your professional life in trying to see if we can’t remove deceptive transactions or deceptive accounting from our financial

world.

It seems to me what we are facing is the following, that we have

both our banking regulators and our SEC doing case-by-case enforcement, that when it comes to banks, we have a gap. We have

a gap because, on the one hand, the SEC does not generally regulate banks, and we, on the other hand, don’t have our banking regulators that do the work relative to banks that the SEC would do

if it did regulate banks.

I know you all work together, and that is really essential, that

you do work together if we are going to overcome and to end some

of the deceptive practices that we have both heard about and we

have written about, our investigation has uncovered, and so forth,

and I am not going to ask you to comment on any specific practice

of any specific institution for obvious reasons.

Is it possible that you could, working together, end that, or fill

that gap in our regulatory regime, in the oversight that you carry

out, because the SEC doesn’t generally regulate banks and the

bank regulators don’t generally regulate accounting practices or ensure accounting financial statements, we have got that gap. Unless

we have our regulators working together, we are not going to be

able to deter. We may be able to, on a case-by-case basis, get to

a problem in terms of punishment after the fact, but in terms of

examining the books of financial institutions, we are not going to

be able to do the deterrent work which is usually available in most

regulatory bodies. We need a deterrence program.

I would like you to react to the following approach. First, that

the SEC issue a clear policy statement, that the SEC would take

enforcement action against financial institutions which aid or abet

a client’s dishonest accounting, or, of course, if they participate in

a deceptive structured transaction. We know the SEC has the authority to go after aiders and abetters, but what I am suggesting

here is not just a case-by-case going after an aider or abetter, but

issuing a clear policy statement that the SEC would take enforcement action against financial institutions if they aid or abet a client’s dishonest accounting or participate in a deceptive structured

transaction. Now, that would be the SEC side of the two-step action which I am suggesting.

79

The second step would be by the bank regulators, here, informing

the banks that violation of that SEC policy which I have just described would constitute an unsafe and unsound practice. That

would enable bank examiners to take appropriate action during

regular bank examinations.

If the SEC issues a clear policy statement relative to aiding and

abetting by the financial institutions and if then the banking regulators as part of their regular bank examination let the financial

institutions understand that a violation of that SEC policy, in turn,

would constitute an unsound and unsafe practice, we then will

have addressed this gap which exists, which I think most people

would agree should somehow or other be filled.

So I am wondering whether or not I could get a reaction from

our three witnesses today to that, and if that is something which

needs to be looked at, fine. If there is a different approach where

you can join together to fill this regulatory gap, then we would welcome your comments on it. Let me take you in the same order that

I called on you before. Mr. Spillenkothen.

Mr. SPILLENKOTHEN. Mr. Chairman, I think if the SEC had a requirement that said a certain activity was a violation of securities

laws or a violation of the law or securities regulation, then I think

it would be the responsibility of bank regulators, if they found a

situation that was a violation of an SEC rule, to take action, to

deal with that, take enforcement action or refer to the SEC.

So I would, again, without having had a chance to work this

through entirely—I am not a lawyer—but if an activity is clearly

stated, if an activity is a violation of a securities law or regulation

that the SEC has established or that is established, then I would

think banking regulators would have no difficulty in taking steps

when they found a violation. Obviously, you still have to make a

judgment as to whether the organization is violating the law. But

if the clear established rule is that a certain activity is a violation

of the law, then the bank regulators would take an action it would

be unsafe and unsound to violate securities law.

Senator LEVIN. This would be part of their bank examination, or

it could be part of their routine, regular bank examination?

Mr. SPILLENKOTHEN. If we found a violation of a securities law,

we should take action or refer to the SEC in the course of our ongoing supervisory process, yes.

Senator LEVIN. You say law. My reference and my question was

to either a law, regulation, or a policy clearly stated by the SEC

as to what action they would take if they found certain activities.

So I tried to identify the word ‘‘policy.’’ Now, it can’t just be general

and it can’t just be oral. It would have to be a clearly stated enforcement policy of the SEC, obviously, but would that do it or does

it have to be a regulation?

Mr. SPILLENKOTHEN. I am not a lawyer, sir.

Senator LEVIN. OK. If you could just take that back to your lawyers, I know they are waiting for work and will welcome the question. [Laughter.]

Senator LEVIN. Mr. Roeder.

Mr. ROEDER. If the SEC issued a policy statement as you indicated, I think from our standpoint, a bank that would violate that

statement, we would consider that an unsafe and unsound practice,

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because as Mr. Spillenkothen indicated, we expect banks to obey

and comply with law.

If we, in our examination process, detected noncompliance with

that statement, in addition to referring that matter to our colleagues at the SEC, our own current enforcement authorities allow

us to initiate action against an institution ourselves for unsafe and

unsound practices. So I think what you propose is workable.

Senator LEVIN. Thank you. Ms. Nazareth.

Ms. NAZARETH. I think to a large extent, what the Commission

does is consistent with the spirit of, I think, what you are looking

to achieve. Our enforcement actions are all settled pursuant to SEC

orders that are very highly negotiated and contain, I think, very

clear articulations of what is the Commission’s position with respect to the activity, and as you know, we have a—one reason why

people find it particularly painful to have had an enforcement action with the SEC is that we really name and shame. We are quite

public in these actions in terms of making public what the activity

was and what the Commission’s articulation of the issue was.

In the cases that you are discussing, those cases would be

brought under our general anti-fraud authority. I think that, in

general, our position is that we want it very clear—in other words,

we would want to make it very clear to people, as we have in some

of our recent aider and abetter cases, that there is aiding and abetting liability for this type of activity. You can see the specific examples in those cases as to what resulted in aider and abetter liability.

But we, frankly, by not putting out a specific policy statement,

we don’t limit the context or the fact patterns in which we could

find that activity to be violative, which I think is important. We are

careful not to find ourselves in a position, I think, where ultimately

someone could say, well, what I did was technically around the

edges of your policy statement. Rather, I think we leave ourselves

sufficient room so that regardless of how imaginative some of these

schemes can become, that we will be on all fours in being able to

bring a case against the parties.

But again, that having been said, I think the language is quite

clear in these enforcement orders and would provide sufficient

guidance to other regulators to ascertain what we had found to be

a legal activity, and I suspect as a result of all of this, all of us

at this table and other regulators, as well, will be thinking through

our own, as we have testified, our own examination procedures in

terms of the kinds of activities that we will be looking for, the

kinds of internal procedures that we will expect these entities to

have in order to ensure that they are not engaging in these types

of activities.

Senator LEVIN. Would you take up with the SEC the suggestion

that you adopt a policy statement relative to types of special purpose entities or structured transactions which you would consider

to be improper? The advantage of that, obviously, is the one that

I set out, that then the banking regulators would have not just the

case-by-case results from your shop, but would have a policy statement which could appear prospectively. They wouldn’t have to just

interpret from a case or a finding in a specific case from a different

agency, but they would have a policy statement of that agency.

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I think if you would be willing to take that back, that idea back,

it also could contain within it a statement that your enforcement

actions are not limited to those particular examples of practices

which you would feel to be deceptive or not reflective of good accounting practices. You could make that clear that those are simply

examples and don’t represent the total universe of what your enforcement actions might be.

But if you could at least consider taking that kind of action, it

would, I believe, be an important step to filling what is a real gap,

and that is the gap which I have identified, which is that SEC generally doesn’t regulate banks and that banking examiners generally

don’t do—generally don’t look for the kind of things that you look

at in public corporations in terms of their financial statements. So

would you be willing to do that?

Ms. NAZARETH. Yes, of course, I will take that back.

Senator LEVIN. Let me turn now to Senator Bennett for a time.

Senator BENNETT. Thank you, Mr. Chairman. I apologize to the

members of the other panels that I missed. I had a longstanding

lunch engagement that I felt I had to keep, but you are still going

forward, so I appreciate the opportunity to be back here.

One of the things that has come out of all this is a recognition

that contrary to general impressions, accounting is not an exact

science. Indeed, accounting can be quite philosophical.

My brother, who taught philosophy at the University of Utah, described getting acquainted with the new head of the accounting department at the University of Utah and the two of them would go

to lunch together and discuss the philosophy of accounting, and interestingly enough, this fellow, whose name I do not know, was ultimately asked to leave the University of Utah because his philosophy of accounting was sufficiently upsetting to other members of

the faculty, that even though his recruiting had been considered a

great coup by the university at one time because he had something

of an international reputation, it didn’t mesh culturally with the

other members of the faculty and he was ultimately asked to teach

someplace else.

I think the average person on the street thinks of accounting in

the same terms as he does balancing his own checkbook or filling

out his tax return and doesn’t realize that there are all kinds of

different ways that you can account for economic activity and all

kinds of justifications that can be raised and defended for these different approaches.

So the challenge that you face as regulators is not just one to

make sure that the checkbook balances and all the numbers add

up, but that the philosophy, if I can use that term, that is being

applied will, in fact, be the clearest statement of what things really

are.

In the Banking Committee, we have had long and sometimes acrimonious debates about accounting in mergers and acquisitions, of

whether you do it on a pooling basis or a purchase basis, and those

that favor pooling insist that philosophy of accounting is responsible for the boom of the 1990’s, and those that favor the purchase

basis insist that pooling is a shell game that is hiding real value.

The question that the Chairman of the Banking Committee, Senator Graham, raised, was is there really a depreciation of the value

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of some of the intangible assets? For example, does the reputation

of Coca-Cola really go down to nothing over a 40-year period? Does

the value of the Coca-Cola formula depreciate over time that can

show up as a number on the income statement or in the balance

sheet? And we debated that with all of the fervor of medieval

theologians discussing how many angels can dance on the head of

a pin.

I would like your reaction to the following that has come to me

as I have listened through all of this and contemplated the true

disaster that Enron represents. It was a disaster for its employees

and a disaster for its shareholders, but as I have reviewed the testimony of Muriel Siebert, it was also a disaster for the system as

a whole and shook investor confidence in the entire American system in a way that we are still living with.

You can manage earnings. That is a phrase that has come out

of the whole Enron experience, that executives are managing earnings so that they will meet the numbers that the analysts have projected. I have been the CEO of a company and I know how, very

rudimentarily, how to do some things to produce that result, how

to put a particular loss in this quarter as opposed to next quarter,

how to set up reserves that are perfectly legitimate, but you set

them up in such a way as to manage how much money shows up

on the bottom line. You can’t manage cash flow. The cash is either

in the bank or it is not. You can’t fudge that one.

As we are debating what to do about the economy in the next

year, one of the proposals that is on the table has to do with the

deductibility or tax treatment of dividends, and it has occurred to

me that if we were to make dividends tax deductible or tax free to

the individual investor who receives them, the investor would,

therefore, have an incentive—economics is all about incentives—

have an incentive to purchase a stock whose return could rival that

of municipal bonds.

Management would have a very difficult time managing the dividend flow, managing the cash flow that would make it possible to

pay dividends. It would be much more difficult to try to manipulate

market perceptions of your company if you had to come up with the

cash every quarter to maintain your dividend payment in order to

maintain your stock price, and that would change the incentive on

the part of the CEO very dramatically.

Instead of going into his CFO and saying, ‘‘Find me an offshore

special purpose entity that I can play with and pretend I have created earnings,’’ the CEO would go to his operational leaders and

say, ‘‘Find me a place where I can get a little more cash so I can

meet my dividend so that my stock price won’t be hurt if the dividend is cut.’’

In today’s market, it is considered a sign of weakness if a company pays dividends. I remember speaking to a CEO of a company

that was awash in cash and saying to him, why don’t you pay some

dividends, and he said, ‘‘If we paid dividends, it would be an admission that we were not in a position to earn more money for our investors’ dollars within the company than they could earn with

after-tax dollars investing it themselves, and we don’t want to

admit that we are not good enough managers to do better with

their dollars keeping them here as pre-tax dollars than we would

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be if we gave them the money and then they had to pay taxes on

it and then they could get a still better rate of return.’’

Now, I know this is economic policy. I know this is part of the

tax debate. But thinking of it in terms of a corporate governance

issue as opposed to a tax issue, do you see any change in corporate

behavior if dividends were tax-free to the recipients and, therefore,

corporations had a strong incentive in terms of the impact on their

stock price to accumulate enough cash, not phony accounting activities, cash, to be able to pay out dividends?

I would appreciate any reaction you might have. This is a little

bit afield from what we have been talking about, but it is very current in what we will be talking about in January and it has come

to my mind as I have tried to think my way through Enron and

what could have been done to prevent it. If the Enron executives

had had an incentive to meet genuine cash responsibilities, they

would probably not have engaged in some of the very high-risk activities that they did engage in. I would like your reaction.

I have caused all three of you to look at each other and smile.

I won’t interpret that as being, this Senator is completely out of his

mind, but a more benign interpretation, but whoever might want

to take it.

Mr. SPILLENKOTHEN. Well, Senator, you are right, this question

is beyond my bailiwick as a mere bank supervisor, so I don’t have

a good insight there. I think your point about accounting being not

science certainly is a true one and I think that—but we would

argue as a bank supervisor that banking organizations and private

sector firms still have an obligation to get the accounting right.

Senator BENNETT. There is no question about that.

Mr. SPILLENKOTHEN [continuing]. An obligation to get it right,

and speaking as a bank supervisor, I am very strongly supportive

of efforts by the Financial Accounting Standards Board, by the

Congress in establishing reforms. We think the progress on getting

the Auditor Oversight Board set up and getting that process working to provide more discipline to the accounting profession are all

very good things and they are very critical for bank supervision.

So I don’t have an opinion on your original point, but getting the

accounting right, bringing discipline to the accounting profession,

bringing to bear some of the reforms that this Congress has established, the oversight board for accountants, the Auditor Oversight

Board, the reforms that the FASB is trying to do, the steps that

the SEC has been taking to improve disclosure and accounting are

very critical to our role as bank supervisors.

Ms. NAZARETH. I feel like it is a trick law school question.

Senator BENNETT. Not at all. I am unburdened with a legal

education——

Ms. NAZARETH. Excellent.

Senator BENNETT [continuing]. So you can go in any direction

you want.

Ms. NAZARETH. Well, I can assure you, a legal education doesn’t

necessarily bring you to the right answer.

It is not clear to me as a lawyer and as a securities regulator

what the consequences of that would be from a corporate governance perspective. I really haven’t had time to think it through.

84

I think what it is fair to say, though, is that I think we do need

to continue to think creatively about ways that we can appropriately incent companies, incent boards of directors, to act in the

best interests of shareholders, in the best interests of their corporations and their businesses, and to account for their activities in appropriate ways. And so, certainly, that is a creative idea that we

could consider, as well as others, to get to that desired goal.

Senator BENNETT. As I say, economics is about incentives, and as

I have gone through the Enron disaster, I realize there was a

strong incentive in terms of the stock price to, again the phrase I

mentioned this morning, be aggressive in reporting earnings, a

strong incentive in terms of the stock price to find every possible

way within the law, if you were determined to abide by the law,

or outside the law if you were of that mind, to account for earnings

in a way that would inflate them and hope that somehow the real

business would catch up with that later on and you wouldn’t get

trapped.

But I am old enough to have come from the school that says you

manage the business properly and the earnings take care of themselves, and ultimately, they take care of themselves in the terms

of money in the till. If you could share that money with your investors without their having to pay the double taxation on it, that becomes an incentive to move in the other direction. I won’t berate

that hobby horse any further. We will have debate about that.

Mr. Chairman, I appreciate your indulgence. I noticed going

through Mr. Spillenkothen’s statement, his statement more clearly

than I made it this morning on an issue that came out of this

morning’s comment, where he says banks should not be held legally responsible for the judgments, actions, or malfeasance of their

customers, nor should they be required to second guess their customers’ accountants, tax, or legal experts, or police their customers’

activities. Such an expectation would require, inappropriately,

banking organizations to assume management responsibility for

their customers and place potential legal liability on banking organizations that would compromise their ability to perform their role

as financial intermediaries or threaten their safety and soundness,

and that is the point I was trying to make this morning, sir, and

you have made it more eloquently.

But you say in the next paragraph, as we all agree, that banks

must not participate in activities of their customers that the banks

know to be illegal or improper, and that is the area that the Chairman is looking into, very appropriately.

Thank you very much for your testimony.

Senator LEVIN. Thank you very much, Senator Bennett.

We have all encountered some of the deceptive accounting practices since Enron in various forms and guises. In one instance that

we discussed today, three senior officials of the investment bank

told the head of the investment bank not to go forward with a

transaction. They used words like it would put the reputation of

the franchise at risk, but nonetheless, they proceeded because

Enron had pressured the bank to go forward.

So you have got client pressure, you have got competition pressure, and in the last few years, banks have begun competing for

business on the basis of who can sell the product that makes the

85

client’s financial statement look the best, and that is the race to

the bottom. So our banks and our security firms need accurate financial statements, but too often, instead of promoting honest accounting, they have been sold and are selling products that produce

dishonest accounting.

I just really need a good, clear statement from our regulators,

because you are at the top of your professions, that this is unacceptable, that our financial institutions have got to stop facilitating

accounting deceptions, they have got to stop helping clients manipulate their financial statements. I would ask you for a clear statement of that without commenting on any specific case.

Mr. SPILLENKOTHEN. Mr. Chairman, I think in my statement I

indicated that we do not think banks should engage in borderline

transactions because they can pose operational and legal risks to

the bank and they can also expose the bank to risks and ultimately

risk to the depositors and the insurance funds. So we do not believe

banks should engage in borderline transactions.

Ms. NAZARETH. I concur with that statement, as well.

Mr. ROEDER. And I take no disagreement with that.

Senator LEVIN. Now, when it comes to the area of structured finance operations at banks and security firms, the question is how

do you separate the legitimate from the illegitimate. There are obviously some legitimate purposes, as we have all indicated, for

structured finance operations, but there are some clearly illegitimate uses to which they have been put, where there is no business

purpose, where all they have been used for is to try to turn a loan

into income or to try to pretend that there was an asset sale when

there wasn’t, there was a loan, where you have this kind of deceptive structure which is created.

We have got to, if we are going to restore confidence in these financial statements, we have got to be able to identify, describe

what separates the wheat from the chaff when it comes to these

structured finance operations. Would you be willing to conduct, or

take back to your agencies the suggestion that there be a joint review of structured finance operations at banks and security firms

in order to identify the ones which are promoting deceptive accounting and to distinguish them from the legitimate uses of these

structured finance operations? Would you be willing to take that

suggestion back about such a joint review? Let me start with you,

Mr. Roeder.

Mr. ROEDER. I think we have to absolutely work together, and,

of course, do so around the ongoing matters under review or investigation within our agencies.

One of the difficult things, as you mention, is separating good

from bad, especially considering the large number of transactions

that these banks conduct. Fortunately, the transactions that we

have talked about today are, we believe, limited in banks.

In addition, the life of some of these transactions is very short,

so the scope and how you might go about conducting that review

would clearly be something we would have to spend time talking

about. We are all faced with limited resources, so I think you have

to bear down on those things that are very complex and assess the

reforms that the banks have adopted and try to determine how you

could extract best practices in hopes that would lead us to maybe

86

a better differentiation between what is appropriate and not appropriate. But I think a coordinated review, as long as it doesn’t

interfer with our current reviews, is sensible.

Senator LEVIN. Ms. Nazareth.

Ms. NAZARETH. I think that there are a number of lessons that

we are going to—that will ultimately emerge from this period and

I think it would be incumbent on all the regulators to look back

on this after we have completed all these enforcement investigations and see what the lessons learned are.

Certainly, I think we will be much more knowledgeable about the

types of transactions that were problematic. I think we could share

information on that, and perhaps with assistance from the various

auditing and accounting groups who assist us in these efforts, perhaps we could try to give some guidance for terms of what we saw

that was problematic.

Senator LEVIN. Thank you. Mr. Spillenkothen.

Mr. SPILLENKOTHEN. Thank you, Mr. Chairman. As I said, the

Federal Reserve is actually reviewing a handful of organizations

that are engaging in these transactions, so we are involved now in

a review of these transactions. We are consulting with our colleagues at the OCC and the SEC in this process, so we will continue that.

As I indicated, we will, after this process is finished and we have

had a chance to assess our results, consider the need for additional

supervisory guidance to our examiners or to the industry. We will

consider the need for additional sound practice guidance in some

of these procedures that the banks are putting in place. I think the

banking organizations themselves have recognized, as they have indicated to you, that they need to revise their internal controls and

vetting processes.

So we are engaged in a review and we will consider, after that

review is done, whether we need to provide additional supervisory

guidance or sound practice guidance in this area.

Senator LEVIN. What is the time table for that review?

Mr. SPILLENKOTHEN. Hopefully in the next weeks and months. I

don’t know exactly. We have got a lot of people doing a lot of

things, but we are attempting to get this done.

Senator LEVIN. Do you expect perhaps in a few months, it would

be done?

Mr. SPILLENKOTHEN. I would hope so.

Senator LEVIN. Do you think it is likely that you will be issuing

some guidance which we could, or you could label as being guidance that was contributed to by the other regulatory agencies?

Mr. SPILLENKOTHEN. Well, we would certainly coordinate with

the other agencies. We also need time to make our own assessments, and I think I should also point out that whatever we do,

we would have to go to our oversight board and make an evaluation of all this. But we certainly would do this in coordination with

the other regulators.

Senator LEVIN. One of the recommendations we will be making

in our report is that there be that kind of a joint review so that

we can have that kind of guidance come from not just the Fed, but

from all of our regulatory agencies working together. It would be,

I think, a very important step in what we are trying to accomplish.

87

1 Exhibit No. 370 appears in the Appendix on page 701.

2 Exhibit No. 369 appears in the Appendix on page 687.

Some time ago, if you could take a look, Mr. Spillenkothen, at

the exhibits—let me see if I can find the number here—Exhibit

370.1 I think we shared this with the folks at the Fed some time

ago. This was an e-mail back in 1999 that is dated March 5, 1999,

and it is entitled, ‘‘Disguised Loans.’’ It says that we are making

disguised loans, usually buried in commodities or equities derivatives, and I am sure in other areas. With few exceptions, they are

understood to be disguised loans and approved as such, but I am

queasy about the process.

And then the employee of Chase listed a number of concerns, and

one of which he said was he worried about loans that escape routine transparencies. The loan is buried in the trading books, and

when we say we have X loans to Country Y, it is not included. And

then he says further down, as a policy matter, I think we need a

small task force to not eliminate disguised loans, but to make sure

they are done right.

I am wondering if your staff at the Fed has talked to you about

it, are you aware of it, and whether anyone has talked to Chase

about that.

Mr. SPILLENKOTHEN. Mr. Chairman, I——

Senator LEVIN. It does address a safety and soundness problem.

When a bank evaluates risk, how much of its money is tied up in

a particular country or company or currency, how does it take into

account all the loans disguised as energy trades or derivatives or

asset sales and so forth? How do you do a risk analysis when you

are missing important transactions? Are you familiar with this

particular——

Mr. SPILLENKOTHEN. Not in detail. I think because we are reviewing these transactions, I really can’t discuss specific questions.

Senator LEVIN. All right, fair enough.

Mr. Roeder, your office at the OCC oversees about 2,000 national

banks, and you stated in your prepared testimony that complex

structured transactions such as those entered into by Enron are

generally offered at only a small number of large banking companies. About how many banks are we talking about?

Mr. ROEDER. Our review would indicate fewer than ten.

Senator LEVIN. So that the banks that would require extra scrutiny on structured finance would be a small population?

Mr. ROEDER. There are a number of institutions that offer very

standard structured finance products and services. The most complex products tend to be concentrated in fewer than ten institutions. So, yes, it is not something that we have found to date to

be widespread.

Senator LEVIN. Therefore, I presume that makes the regulatory

burden a little narrower in terms of the targets?

Mr. ROEDER. It helps, yes.

Senator LEVIN. One last document.2 This was a Chase document,

too, in which it was back in 1998 selling or pitching prepays and

used the term ‘‘balance sheet-friendly.’’ I take it you would all

agree that our balance sheets should be accurate, neither friendly

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nor unfriendly, but accurate. Would that be a fair statement, Mr.

Spillenkothen?

Mr. SPILLENKOTHEN. That is a fair statement.

Senator LEVIN. Ms. Nazareth.

Ms. NAZARETH. Yes.

Senator LEVIN. And Mr. Roeder.

Mr. ROEDER. Absolutely.

Senator LEVIN. OK. Let me close by thanking you all. It has been

a long day, but we have learned a lot. A lot of practices which we

believe are deceptive have been analyzed. Some of our leading financial institutions, in our judgment, helped Enron cook the books,

and the safety and the soundness and the vitality of our financial

system depends on honest accounting and accurate financial reporting. So we need these banks that are the guardians and promoters of honest accounting to be that and not willing accomplices

in accounting deceptions.

We have heard testimony today which is extremely troubling

about the extent of financial deceptions that Enron and its banks

engaged in. The banks say that they recognize the problems now.

They are changing the way in which they do business, and they say

what was acceptable a year ago is not acceptable today. Hopefully,

they will take the actions that are promised.

But we simply cannot rely upon self-regulation and promises. We

need our regulators to step in, ratchet up efforts to ensure honest

accounting, and put an end to banks assisting their clients to

produce deceptive financial statements.

The gap now in the regulatory oversight area needs to be closed,

the gap that exists because the SEC does not generally regulate

banks and the bank regulators don’t generally look at accounting

practices or ensure accurate financial statements. We need to continue the effort to get regulators working together, of course, punishing wrongdoers on a case-by-case basis, but that is not enough.

We need to design a new deterrence program.

It needs a lot of work. Steps need to be taken together by our

regulators, our watchdogs. I have outlined a couple steps that I

thought would be useful, and we welcomed our witnesses’ willingness to take those suggestions back to their agencies. We will make

those suggestions, as I indicated, part of a Subcommittee report

based on our staff investigation and our staff report.

It would be very helpful if the SEC would issue a clear policy

statement, that the SEC will take enforcement action against financial institutions that aid or abet dishonest accounting by a client. At the same time, we need bank regulators to tell banks that

violation of such an SEC policy would constitute an unsafe and unsound practice, which would then enable bank examiners to take

appropriate action during regular bank examinations.

A comprehensive joint review, such as apparently is being undertaken by the Fed, would be very helpful if it is a joint review of

the structured finance products that are being sold or participated

in by our financial institutions so that we can clearly separate the

products and the structured finance arrangements which are deceptive from the ones that serve a legitimate financial and economic

purpose.

89

The short story is that we need to send our financial firms, some

of which are the most renowned firms in the world, much less in

the country, we have got to send them an unmistakable message,

that while we welcome their self-regulation and their growing

awareness of what they participated in, willingly or unwillingly,

wittingly or unwittingly, the message has got to be that touting

balance sheet-friendly deals that allow clients to hide debt or to report deceptive amounts of cash flow or earnings are simply not

going to be tolerated. Our financial institutions must be part of the

restoration of credibility by helping us to return to that good old

fashioned honest accounting.

We all look forward to working with the banking industry and

the regulators to get that message out and to establish that deterrence program that is needed to prevent future calamities, such as

Enron.

We again thank all of our witnesses here today. We thank our

last panel for your patience, for your contributions, and most importantly, for the day-to-day work that you are engaged in and

committed to, in which we place so much faith, that you will take

aggressive actions against wrongdoers where you find them and

that you will help us design a deterrence regime and a procedure

so that we can deter wrongdoing in the future.

With that, we stand in recess.

[Whereupon, at 3:17 p.m., the Subcommittee was adjourned.]

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Æ